If You’ve Fallen Behind on Your Mortgage, a Loan Modification Could Help. Here’s How It’s Different From Refinancing

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When the pandemic arrived in March 2020, it sent many Americans into financial precarity, leading millions of homeowners to sign up for mortgage forbearance — a pause on payments — that ended in June 2021.

By now, the majority of those homeowners are back on track. But for those who are still struggling, a loan modification might be their next step. A loan modification is an opportunity for homeowners to reach a compromise with their lender and ultimately make their payments more affordable.

But how does that path compare to other options, like refinancing? Experts say each choice makes sense for specific types of borrowers. Here’s everything you need to know to make that decision for yourself.

What Is a Loan Modification?

A loan modification is when the borrower requests a change to their mortgage’s loan terms, usually to make it more affordable. In general, you’d only consider a loan modification if, for some reason, you’re not able to make your payments, says Jodi Hall, president at Nationwide Mortgage Bankers, a mortgage company based in New York. 

“A lender will work with you, oftentimes if you’ve been falling behind on your mortgage or getting into a financial hardship,” says Matthew Stratman, lead financial advisor for South Bay Planning Group, a financial planning group based in California.

This doesn’t mean you can modify the terms just because you want to. A loan modification is usually a last resort for people who have fallen behind on payments, whose income has dropped significantly, or who are facing foreclosure

“Typically, there has to be extenuating circumstances for [loan modification requests] to be approved,” Hall explains. 

If the modification is approved, the loan is updated with new terms designed to help you catch up on payments. That can take the form of temporarily reducing the interest rate, forgiving some of the interest, or extending the loan term to lower the payments. 

Pro TIp

Loan modification can be an intense and drawn-out process. Experts say to think of it as a last resort.

The most common situation when loan modification makes sense is after a job loss. This happened for many borrowers during the pandemic, Hall says, but a loan modification can also be used after the death of a spouse or a severe drop in income.

“Many people have short-term problems [where] a modification can be that solution,” Stratman says.

Pros and Cons of Loan Modification

Loan modification can be a good solution for borrowers who are in a tough spot and have missed a few months of payments. However, there are some downsides as well: 

Pros

  • Makes your loan more affordable

  • No closing costs

  • No lump-sum payment to “catch up” on the loan

  • Better alternative to foreclosure

Cons

  • Extending the repayment period of the loan and potentially paying more in interest over the life of the loan

  • Potential negative impact on your credit score

  • An intense amount of paperwork

  • A lengthy (sometimes months-long) approval process

What Is Refinancing? 

Refinancing is when you replace your current mortgage with a new one, typically with a different interest rate. It’s a popular option because it allows you to get a lower interest rate, change your loan term (for example, from a 30-year to a 15-year), or extract equity from your home if you so choose.

Here’s how it works: You take out a new mortgage — either with your original lender or a new one — with new terms and new closing costs, then use the money to pay off your existing mortgage. That means you can take advantage of current interest rates, but it also means resetting your 15- or 30-year loan term. 

Getting a rate-and-term refinance could lower your monthly payments and save you money in the long run if the new interest rate is lower than your original rate. “Rates have been really low right now, so that’s a benefit,” Stratman says. Just be sure to factor closing costs into the equation when calculating how much you could save from a lower rate. 

Another common reason to refinance is to tap into your home equity for quick cash through a cash-out refinance. With a cash-out refinance, you take out a new mortgage that’s larger than what you currently owe, reducing your equity (your home’s market value minus what you currently owe on your mortgage) in your home but letting you pocket the extra as cash. “Right now with where interest rates are, it still makes sense to a lot of people to use that cash for remodeling or use that cash to pay off higher-interest-rate debt,” Hall says.

Pros and Cons of Refinancing 

Refinancing can make sense if you can score a lower interest rate, want to access the equity in your home, or both. It’s especially popular in the current rate environment, but it’s not without its drawbacks: 

Pros

  • Potentially lower interest rate and monthly payment

  • Ability to turn your home equity into quick cash as an alternative to higher-interest debt

  • Faster and less paperwork than a loan modification

  • Refinancing doesn’t hurt your credit score

Cons

  • Refinancing involves closing costs

  • Losing your original interest rate

  • Resetting the clock on your mortgage payment term

  • Must stay in the house long enough to recoup the upfront costs

Main Differences Between Modification and Refinancing 

In some ways, loan modification and refinancing can accomplish similar goals — changing the terms of your mortgage — but they involve very different processes. For one, a loan modification keeps your original loan intact, while a refinance essentially entails starting all over again with a new loan.

The biggest difference between a loan modification and refinance, however, is what situations each one is meant to be used for.

A refinance is generally used by those in a solid financial position wanting to reduce their interest rate or tap into their equity. Refinancing can lower your monthly mortgage payment, but if you’re currently having trouble affording your monthly payments as-is, you might not be in a position to refinance. 

Lenders won’t allow you to refinance a mortgage that’s already in default, and it can be hard to get approved for a refinance at a good rate if your credit has been damaged by previously missed payments. Refinancing also comes with closing costs that can be an added financial burden.

A loan modification, on the other hand, is generally used by borrowers who are already having trouble paying their mortgage and have no other option to get a lower payment.  If you want your lender to grant you a loan modification, you will most likely need to show proof of economic hardship. 

In addition, a loan modification could potentially hurt your credit score, although it’s still a better option than letting your mortgage go into default and foreclosure. But, it’s not supposed to be your first resort if you just want a lower monthly payment.

Each option also involves varying timelines and levels of paperwork. Here are some other important differences you should be aware of:

Loan ModificationRefinancing
The purpose of doing itTo change the terms of the loan, usually in the form of lower payments, and avoid foreclosureTo extract equity from your home, get a lower interest rate, or pay the loan off sooner
Who it’s forBorrowers who’ve fallen behind on payments or who can no longer afford the paymentsBorrowers who want to access home equity or take advantage of low interest rates
How long it takesMultiple monthsA few weeks
How it worksThe existing loan is recast with a new (usually longer) term or new (usually lower) monthly paymentsThe existing loan is paid off and a new loan is created with the new rate and terms
Where to startContact your existing lender to discuss what your options areContact your existing lender or a new lender to inquire about refinancing rates and closing costs

Is a Loan Modification or Refinancing Better for Me? 

In some ways, the choice between a loan modification or a refinance isn’t much of a choice at all; it’s largely determined by your circumstances.

“I don’t think anyone wakes up in the morning and says, should I modify my loan or refinance it?” Hall says. That’s because loan modification is almost always a last resort for borrowers who are already behind on their mortgage, and would not qualify for a refinance. “For those who are unable to make their payments, their only option is the modification process,” she explains. 

If you’re not behind on payments, then you can take a loan modification off the table completely, Hall says. The question then becomes: Should you refinance or not?

You can make that decision by weighing the potential costs and benefits of a refinance — both monetary and otherwise.

The biggest thing to consider when deciding if a refinance makes sense for you is whether you plan to stay in the house long enough to recoup the cost. Refinancing usually comes with closing costs, which typically range from 2% to 5% of the loan amount and can add up to a couple thousand dollars. 

If you don’t keep your new loan for long enough — whether because you move or decide to refinance again — the money you save with a lower interest rate won’t be enough to cover the upfront costs. You can use NextAdvisor’s refinance calculator to find the break-even point and decide whether a refinance makes financial sense in your situation. 

There are also some other, non-money factors to consider: refinancing essentially “resets” your loan term, meaning you’ll be starting again from year 0 on a 30 or 15-year loan. This could mean it’ll take longer for your loan to be completely paid off, unless you refinance to a shorter loan term.

In addition, even if market interest rates are low, be aware that your individual rate will be determined by your creditworthiness and financial profile. If your credit score has dropped since the time you first took out the loan, you may not get a better rate at all if you refinance. 

Given the current rate environment, refinancing can be a smart financial move for many homeowners. It’s worth it to take a few minutes to review your options and crunch the numbers to see if it’s right for you. 

At the end of the day, refinancing is an option for borrowers in a strong position, and mortgage modification is an option for borrowers who are struggling.

“One is right for one category of people, and the other is right for the other group of people who have the option,” Stratman says.

But no matter what situation you’re in, Hall emphasizes that you should not go about the process on your own. “It’s important for people to have a licensed loan officer they’re working with who can act as their trusted advisor,” she says. “For most people, it’s a very daunting task to do either.”