The combination of falling incomes and home values has many homeowners seeking loan modifications to lower their monthly mortgage payments. And while saving money is always a good thing, some may wonder - are there any downsides to getting a loan modification?
The simple answer is yes - although the negatives may not outweigh the advantages of lowering your monthly mortgage payment in the first place. But they're still something borrowers should be aware of, in order to avoid potential pitfalls and know what to expect out of the process itself.
A loan modification, of course, is when a lender (usually the bank servicing the mortgage) agrees to modify the terms of a mortgage to make it more manageable for a financially stressed homeowner. It may involve reducing the interest rate, extending the term of the loan, restructuring the payment schedule or other adjustments. Although loan modifications conducted under the Obama Administration's Making Home Affordable (MHA) Program are getting most of the attention these days, most lenders have their own in-house loan modification programs as well.
Credit score may be affected
One of the biggest downsides is the potential effect on your credit score. Many homeowners who obtained trial loan modifications under MHA have reported taking a hit on their credit scores of 50-150 points. Some banks report loan modifications as a partial payment on the debt or even as past due (in the case of an MHA three-month trial modification), although reporting practices vary by lender. The industry is supposed to be adopting new credit reporting guidelines to address this problem, but it remains to be seen what effect they'll have.
Generally, the higher your credit score, the bigger the impact - if you've already missed a couple payments or your score is in the mid-600s or below, you won't see as much of an impact. But if you have a score in the 700s, getting a loan modification could reduce your credit and make it more difficult for you to get an auto loan or might result in higher interest rates on your credit cards.
On the other hand, a loan modification could save you some serious money - perhaps $300-$1,000 each month or more, depending on your income and current mortgage payment. With that kind of cash, you may not need credit - although a big-ticket expense like replacing a car or an unexpected major home repair could be a challenge.
No guarantee of a permanent modification
Another potential downside that is widely overlooked is that obtaining a trial modification under the MHA program is no guarantee you'll be approved for permanent status, even if you make all your trial payments on time. Roughly as many completed trial modifications have been rejected as approved for permanent status under MHA, typically because the borrower's income turned out to be inadequate or for other documentation problems.
The big shocker here is that the lender can then turn around and demand that you immediately repay everything you saved during the trial period - that is, the difference between your original payments and the reduced payments you had during the trial period. Given that some borrowers have seen their trial period stretch out to five months before getting an answer from their lender, this can be a substantial amount of money to be repaid - and few borrowers are in a position to set aside the monthly difference until they get a final answer on their trial modification.
A loan modification is also a lot of work. Getting one is a lot like applying for a whole new mortgage, only with more documentation required. It can take months to be approved even for the trial program, and several months after the end of that to be approved for a permanent modification. The mortgage servicer may make repeated requests for more and more documentation, or proof of the validity of documents already submitted. Borrowers who are successful in getting a permanent modification are usually those who continually follow up with their lenders with repeated phone calls, letters and emails. By the time the process is over, they often feel they've earned every cent saved.
Don't assume you'll save money
Be aware, too, that a loan modification may not actually lower your monthly mortgage payment or save you money over the long term. Although both are requirements of loan modifications made under MHA - the monthly payment must be reduced to 31 percent of your monthly pre-tax income under the government program - most lenders also have their own private loan modification programs that aren't bound by those restrictions.
In fact, many private loan modifications actually increase the borrower's monthly payment. These are more accurately described as payment plans, since they're designed to bring a past-due account current by spreading out the delinquent balance over time, on top of the regular payments, but many lenders describe them as loan modifications.
Private loan modifications may also involve such measures as extending the term of the loan, say out to 40 years instead of the 24 the borrower currently has remaining. While this can reduce the monthly payment and be helpful to a homeowner in a tight financial spot, it does increase the interest payments and overall cost of the loan over time.
Private loan modifications can also offer attractive terms, including reductions in the interest rate and occasionally even the loan principal. The key is to understand what is being offered and make a determination of if will provide meaningful help. If it doesn't, it won't help you over the long term - don't be afraid to say so and ask for better terms. The terms of the government's MHA program are predetermined by law, but no such limits apply to private modifications.
Foreclosure, scams a possibility
Remember, a loan modification may not enable you to avoid foreclosure, even after reducing your monthly mortgage payment. Borrowers often adopt a "best-case scenario" when calculating how much of a mortgage payment they can afford on their current income. Unfortunately, those calculations may depend on nothing going wrong, and unexpected expenses or reductions in income can push them right off the fine edge their finances are balanced on.
Finally, one of the biggest pitfalls about loan modification process is that it can make you vulnerable to scam artists. There is no shortage of companies that offer to help homeowners obtain mortgage loan modifications in exchange for steep upfront fees, often several thousands of dollars. Although there are certain circumstances where one may wish to consult with an attorney regarding a loan modification, all too often these companies collect the money and fail to deliver.
Given there is no shortage of HUD-approved credit counseling agencies that will assist homeowners in obtaining a loan modification for little or no cost, most homeowners are far better off saving their money and using it to pay their mortgage, rather than hiring an expensive loan modification service.