Benefits of a Loan Modification
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.
Potential Drawbacks of a Loan Modification
Although a mortgage loan modification can provide substantial benefits, some homeowners may wonder about potential downsides to the process, including effect on credit score, possible costs and tax implications. The following are some of the most common concerns.
Impact on credit score
A loan modification may have little or no impact on a borrower's credit. The credit report of a borrower may indicate that their mortgage was modified, and this will depend on how the lender reports it to the credit bureaus.
However, if the borrower, in the process of obtaining a loan modification has missed any mortgage, or other payments, those will still impact their credit report, regardless of the outcome.
Processing costs and legal fees
When working with a lender, the borrower may find that there are fees involved with completing the loan modification itself. The lender can usually add these to the principal of the loan, rather than ask for them from the borrower, relieving the borrower of having to come up with those funds.
Other fees, such as late charges, that the borrower has incurred prior to seeking a loan modification, can sometimes be added to the loan principal as well.
Borrowers can negotiate a loan modification with their lender on their own. There are nonprofit agencies that will advise a homeowner on obtaining a loan modification for little or no fee. However, some may wish to hire either a consulting firm or engage an attorney on their behalf. These may require a modest retainer up front, but should not require full payment until a modification has been secured. Loan modification firms that require hefty fees up front should be avoided.
Debt forgiveness can be taxable
If the lender agrees to reduce the principal of the loan, thereby writing off a part of the loan amount, the borrower may be liable to pay income tax on it. This is more likely to happen in the case of investment properties, versus primary residences. The Mortgage Forgiveness Debt Relief Act of 2007 makes this forgiveness on primary residences non-taxable in most cases.
A simple example would be if a borrower owed $175,000 on the mortgage for an investment property and the lender forgave $30,000 of it. The borrower might receive a 1099 tax form showing the $30,000 reduction as income, since it represents money the borrower was given and will not have to repay.
Borrowers should check with their tax professional for specifics of their own situation.
Lender may opt for sale of the property
In a situation where a lender is unconvinced of a borrower's long-term ability to make payments, the lender may encourage the borrower to consider selling the property. The lender might also opt to just begin foreclosure proceedings as soon as they are legally able, and bypass the loan modification process completely.
Could I Still Lose My Home?
Loan modifications are extended to homeowners who are facing a financial hardship. The expectation is that the borrower, at some point, will be past that hardship and will be able to resume making their mortgage payments as they did prior to the hardship.
The reality, though, is that many homeowners go through the loan modification process and, after getting into payments that both they and the lender believe are manageable, wind up back in a position of being unable to make their payments.
Whether the second time is a true hardship, or excessive spending on the part of the borrower once they feel that they are getting ahead again, lenders are very reluctant to do multiple loan modifications for any borrower. It may be that the borrower was unrealistically optimistic about their ability to make the new payments, even during the first modification process.
Borrowers who once again find themselves in the position of facing a mortgage payment delinquency and potential foreclosure probably need to ask themselves if the property they are in is the right one for them.