Learn more about loan modification versus refinancing to find out which financing tool might be best for you.
What’s the Difference Between Loan Modification and Refinancing?
Eligibility: Loan Modification vs. Refinance
In general, loan modification is for borrowers who are in the midst of a financial struggle, while refinancing is for borrowers who are in solid financial shape but want a different home loan that benefits them in some way. To be eligible for a loan modification, most lenders will require that you explain your financial hardship and provide documentation. Some might not consider modifying your loan unless you’ve missed payments already. If you have a government-backed loan, there may also be special loan modification programs available. It’s always best to call your lender to ask about how you might qualify for loan modification. Refinance applicants must have ample equity in the home (and will have to prove it with an appraisal), as well as meet all the lender’s requirements, including for credit history, debt-to-income (DTI) ratio, and other criteria.
Potential Benefits: Loan Modification vs. Refinance
The key reasons to seek a loan modification are to avoid foreclosure or having to claim bankruptcy. Each type of loan modification—whether it’s lowering your principal balance, extending your loan term, lowering your interest rate, or switching to a fixed interest rate—is designed to ease your burden by lowering your monthly payment amount. With a refinance, though lowering the interest rate and having a lower monthly payment is usually the main driver, some people may also want to shorten their loan term or to move from an adjustable-rate mortgage (ARM) to a more predictable fixed-rate mortgage or from a Federal Housing Administration (FHA) loan, which requires paying mortgage insurance, to a conventional loan.
Drawbacks: Loan Modification vs. Refinance
With a loan modification, you have to be in financial peril to qualify. While you wait for approval, you may miss payments, which can hurt your credit score. And even when you are approved, it might be reported as a settlement, resulting in another credit ding. With a refinance, the main downsides are that you have to go through a thorough application process (similar to when you bought your home) and pay full closing costs. If you don’t have good credit or steady income (the process may be more challenging if you are self-employed, for example), it might be more difficult to qualify.
Special Considerations
In addition to traditional loan modification and refinance programs, there could be some special programs to consider, depending on your circumstances. For instance, while a regular refinance requires you to have enough equity in the home, there have been some special refinancing programs designed specifically for homeowners with “underwater” mortgages, meaning they owe more than the home is worth. Likewise, you could consider modifying your existing loan on a temporary basis if you don’t want to go through a full-fledged loan modification. In fact, it’s often easier to get help on a temporary basis by requesting forbearance, which is when the lender agrees to either lower your payments or skip payments for a set amount of time.
Which Is Right for Me?
Ultimately, your personal financial situation will dictate if you’re better off applying for a loan modification or a refinance.
Refinancing may be right for you if you…
Have good credit and are current on all of your payments Think you can qualify for a lower interest rate than you currently have Want a lower interest rate, a shorter loan term, or a different type of loan program Plan to remain in the home long enough to recoup the closing costs
Loan modification may be right for you if you…
Can’t qualify for a refinanceAre struggling with your mortgage payments, have missed some, or anticipate that you won’t be able to pay in the near futureCan demonstrate that you’ll be able to afford the lower payment amount
Choosing between a loan modification and a refinance really comes down to asking yourself the following questions:
Are your finances strong or are you faltering? Do you have a solid payment history and credit score? Have you weighed the short-term benefits against the long-term impact of changing your loan terms or refinancing? (A loan amortization calculator can help with that.) Will there be any out-of-pocket costs involved?
The Bottom Line
While loan modifications and refinances have some similarities, they are very different programs for different financial situations. By assessing your financial situation and determining what your goals are, you can determine which is worth pursuing.
