Homeowners who, for whatever reason, find themselves in a position where they are unable, or expect to soon be unable, to make their mortgage payments can realize substantial benefits from getting a loan modification.

There are different ways that loans can be modified, and all of them have the same objective in mind; to keep the homeowner in their home by modifying the mortgage terms and/or the payment so that they are consistent with what the borrower can afford.

There can be benefits for both the lender as well as the borrower, in that it may often be in the best interest of the lender to avoid having to go through the foreclosure process, especially if the borrower is truly having a short-term hardship and will eventually be able to resume making their payments on time.

Extended Payment Terms

One way to reduce the monthly payment on a mortgage without changing either the interest rate or the principal is to extend the term of the loan.

For example, if a borrower has a $150,000 mortgage that they took out at an interest rate of 6 percent for 30 years, the payment on the principal and interest would be $899.33.

If the terms of the loan were extended from 30 to 40 years, the payment would become $825.32, for a savings of $74.01 per month, or just under $900 per year.

The savings each month are definitely a benefit, but the homeowners will now be making payments 10 years longer before their home is paid off.

This may be a viable option though, given the alternative of foreclosure, especially if the borrower intends to move at some point in the future.

Interest Rate Reduction

Lenders will sometimes agree to reduce the interest rate on a mortgage, usually as a temporary measure. Reducing the interest rate on a mortgage for even a short period of time can help a homeowner through a financial crisis. A permanent interest rate reduction is more commonly achieved by refinancing the loan.

Continuing the example from above, if a homeowner with a $150,000 mortgage for 30 years at 6 percent were to get a temporary rate reduction to 4.5 percent, the monthly payment would drop from $899.33 to $760.03. This is a savings of $139.30 per month.

The interest that the lender forgoes during the period when the rate is reduced may be forgiven, but more typically is added to the back end of the mortgage, to be repaid when the loan matures or the property is sold.

Principal Reduction versus Principal Forbearance

These have similar-sounding names but are actually two different things.

A Principal Forbearance is where the lender forgives the interest on part of the principal. They in effect collect zero percent interest on part of the loan. The borrower still owes all the principal to the lender, but will pay it back when the property is either sold or refinanced, or when the loan matures.

A Principal Reduction is just as it sounds. The lender reduces the amount of principal that the borrower owes, with no expectation of repayment. Debt Forgiveness is analogous to a principal reduction.

This is a more effective way to reduce payments than either lowering the interest rate on the mortgage, or extending the terms.

Again in the example from above, if the same homeowner with a 6 percent, $150,000 mortgage for 30 years were to get a principal reduction to $125,000, the payment would go from $899.33 to $749.44, for a savings of $149.89 per month.

Freeing up money for other debt

Borrowers that need a loan modification often have significant other debt, such as auto loans, credit card payments, student loans, etc., that they pay on each month.

One of the criteria that the credit bureaus use in determining credit scores for borrowers is the ratio between the balance and the limit of revolving lines of credit. This means that the lower the balance compared to the limit, the better the borrower is perceived as being able to manage their credit.

Borrowers that are able to lower their mortgage payment will have money each month to pay down, or pay off other debt.

Published on November 23, 2009