Loan Modification vs. Refinance: Which is Right for You?

Changing the terms of your loan or getting a new one can make monthly payments more manageable. Reducing your monthly payments will free up more space for other expenses. Some people also use refinances to tap into home equity so they can cover big expenses. The two most common ways to adjust your loan are through a loan modification or a refinance. This guide will explore the differences between these choices.

What is a Loan Modification?

A loan modification involves changing the rate and terms of your current loan without getting a new loan. Your current mortgage lender must agree to modify your loan. For instance, a borrower can negotiate a lower interest rate if rates have dropped across the industry. Some lenders would rather give you a lower rate than lose you to the competition. Borrowers can also request a different type of rate. For instance, a homeowner with a variable interest rate may ask for a fixed-rate mortgage.

However, loan modifications can also take place because the borrower cannot afford monthly loan payments. The borrower may request an extended loan duration to spread out the monthly payments.

Pros and Cons of Loan Modification

These are some of the advantages and disadvantages of loan modifications.

Pros

• Potentially lower your interest rate
• Reduce your monthly payments
• Switch from a variable-rate to a fixed-rate mortgage or vice versa
• Possibly get a principal forbearance to avoid foreclosure

Cons

• Loan modifications are usually reserved for people who are having a difficult time making payments
• You may stay in debt longer
• Interest can accumulate
• A loan modification will have a negative impact on your credit score

What is a Refinance?

A refinance is the most common way to get a new rate and term for your debt. You will have to apply for a new loan and use the proceeds to pay off your current loan. Borrowers who refinance receive different rates and terms. You can end up with a lower interest rate if market rates have dropped or you have improved your credit score.

Refinances also allow you to take some cash out of your property through a cash-out refinance. Loan modification only lets you adjust the rates and terms, but it doesn’t let you tap into equity. A refinance gives you the flexibility to part ways with your current lender if you find a better option.

Pros and Cons of Refinance

These are the strengths and weaknesses of refinances that are good to keep in mind.

Pros

• Get a new rate and term
• Potentially lower your interest rate
• You may reduce your monthly payments
• It’s possible to tap into equity
• Switch from a variable-rate to a fixed-rate mortgage or vice versa

Cons

• Prepayment penalties
• Closing costs and appraisal fees
• A refinance will have a negative impact on your credit score
• You may stay in debt longer, which allows interest to accumulate

Loan Modification vs Refinance: What’s the Difference?

Consumers who can choose a loan modification or a refinance should assess several factors before getting started. These are the highlights.

Eligibility Requirements

Mortgage lenders want to see that you can keep up with monthly loan payments. You will need a FICO score of 620 or higher to refinance a conventional mortgage. You must also have a debt-to-income ratio below 45%. Some mortgage lenders accommodate borrowers with higher DTI ratios, but a lower DTI ratio will help you get better rates and terms.

While lenders also want to see that you can keep up with modified loan payments, a modified loan is typically reserved for people who aren’t keeping up with monthly payments for their current mortgages. You will have to contact your bank’s loss mitigation department to learn if they offer loan modifications.

Borrowers must provide identification and proof of income for either option.

Cost Comparison

Loan modifications are cheaper since they do not have any closing costs. You also won’t have to pay any prepayment penalties since you aren’t walking away from your current loan. While loan modifications are cheaper, most people won’t have this option. Loan modifications are reserved for individuals who are approaching foreclosure.

Impact on Credit Scores

Both choices will negatively impact your credit score. However, it is easier to recover from a refinance. A loan refinance demonstrates that you want a new rate and term. Some refinances take place because people want to capitalize on lower market rates, while others may want to tap into their well-earned equity.

Loan modifications have a different context. Borrowers can only modify their loans if their finances aren’t the best. People who can keep up with monthly mortgage payments will have to get a refinance instead of a loan modification.

Impact on Loan Terms

You will receive new loan terms with either option. Loan modifications typically adjust your terms so you have lower monthly payments. While refinances can achieve the same objective, some people end up with higher monthly mortgage payments after refinancing.

This scenario can happen for two reasons. A homeowner may initiate a cash-out refinance, which will increase the mortgage balance. A higher mortgage balance will require higher monthly payments unless you stretch out the mortgage. The second scenario is if a borrower opts for a shorter mortgage term. A shorter term gets you out of debt sooner, but you will have to make higher monthly payments for the loan’s duration.

Process

You will have to contact your lender to discuss a loan modification. However, you can do business with your lender or a different mortgage lender if you want to refinance your mortgage. A refinance allows you to shop around and compare rates, while loan modifications do not offer that flexibility.

Mortgage lenders will request similar documents, such as your ID, proof of income, proof of residence, and other resources.

When to Choose Loan Modification

A loan modification is optimal for homeowners who are having difficulty with making monthly mortgage payments. Homeowners in this scenario may be worried about losing their property due to a foreclosure. This path also saves money since you don’t have to pay any closing costs or prepayment penalties.

When to Choose Refinance

A refinance is more suitable for consumers who can keep up with their monthly mortgage payments and other financial obligations. You may also want to pursue this option if you need to access additional capital or want to shorten the duration of your loan.

Making a Decision: Should You Opt for Loan Modification or Refinance?

A loan modification is only applicable to homeowners who need help with their finances. If you qualify for a loan modification and don’t plan on applying for an additional loan or line of credit for several months, this choice may be better.

However, a refinance gives you more flexibility and is more suitable for homeowners who are not in financial distress. You can adjust the rate and terms of your mortgage by getting a new one, and you can choose from more offers. Refinances don’t tie you to your current lender. You can also use these financial products to get out of debt sooner or tap into home equity.

FAQs About Loan Modification vs Refinance