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.

Published on November 23, 2009