Before You Refinance, Look Into Loan Modification

For months now, we've been telling you to take advantage of lower interest rates by refinancing. But you know what? There's another option to consider as well: loan modification. Wait, isn't loan modification what distressed homeowners used to get through the post-2008 housing crisis? Well, yes, but it's more than that. Here's the lowdown, and whether it's the right choice for you.

OK, what's the difference?

If you refinance your home, you're replacing your old mortgage with a new one, whether to take advantage of lower interest rates or to reduce your monthly payment. This can be done by your current lender or a new one. You can choose a loan that's similar to what you currently have -- or something completely different. As always, your creditworthiness, equity, and loan type play a role in determining your rate.

When you get a loan modification, on the other hand, you're tweaking your existing loan from your current lender.

Again, this used to be an option just for people struggling to make their payments -- lenders figured that some money is better than no money. But even if you're not falling behind, you might be able to get a modification in your favor -- even reducing interest rates.

That's right, your lender might -- might -- be able to give you a lower rate for a one-time flat fee.

That sounds like a deal almost too good to be true. Why would a bank lose thousands and thousands of potential dollars in interest for a relatively small fee? Tom Pasqualini of Hudson United in the hamlet of New City, NY, says it's a client-retention tactic -- it prevents you from refinancing through another bank. It's also "the lowest-cost solution for a rate/payment change for a consumer loan they are servicing," he says.

The availability of this service is subjective to each lender, says Pasqualini. "Conservatively, [it's] 50-50 if they offer the service." With so many private lenders all over the country, you'll just have to ask yours.

How much it'll cost you

According to Carlos Jaime, owner of CTC Brokers & Associates in Corona, CA, one-time fees can range from $1,200 to $2,500. Some modifications don't cost a thing.

But there won't be any hidden fees, which is good. "When you elect to modify a loan, there can be no changes other than the rate of interest associated with the loan," says Pasqualini.

If you refinance, remember, you're getting a whole new loan -- at whatever rate and monthly payment you agree to. If you have a no-cost refi and the closing costs aren't paid by the lender, then the closing costs are rolled into the loan or are "bought out" by your accepting a higher interest rate.

There's one thing that loan modification can't do, but refinancing can: write someone in or out of a mortgage. So if you've gotten married or divorced, and want to add or remove a name from the loan, you'll want to refinance, not modify.

Use caution and run the numbers

Be careful what kind of modification you choose. Unlike a good refinance, certain types of loan modification can trap you in surmounting debt.

Here's how it works. Let's say you get your lender to agree to an interest-only loan repayment period of five years, which reduces your monthly payment by $500, with the remaining balance tacked on to the loan. You'll be paying $30,000 less over five years -- but you won't have saved that sum, you'll still owe it. That $30,000 will be calculated into the loan, ultimately increasing your monthly payments by more than you paid before the modification. If you ask your lender for an extension and get one, you could be setting yourself up for trouble down the line.

In fact, a recent study found certain modification programs, such as the Countrywide program, actually induced strategic defaults, so make sure you fully understand any modification before agreeing to it.

Elysia Stobbe, branch manager of NFM Lending in Jacksonville, FL, says modifications can also come with teaser rates, just like mortgages.

"It can be a 2% teaser for the first year, then adding 1% each year for a few years, and then staying fixed in the 5% range," says Stobbe.

Ask your lender

If you want to find out your loan modification options, you first want to identify who owns your loan (not the servicer). You can see if it's Freddie Mac or Fannie Mae by using their websites. Fannie Mae and Freddie Mac both offer the government's Home Affordable Refinance Program and the Home Affordable Modification Program. Both of these programs have broader income and credit requirements and may lessen your monthly payment and rates, if you're eligible. Contact your lender for their requirements.

Even if your lender can't offer you HARP or HAMP, it may have another option to help you out.

Making the choice

Choosing between a modification and a refinance can be tricky. Jaime says the first stop should be to see if you're eligible for HARP for a refinance because of the program's relaxed income requirements. If your lender doesn't offer it, you're ineligible, or you're too underwater for a traditional refinance, it's time to look into modifications. Consider the following:

  • How long will you live in the home? If you're not planning on staying for the long term, it might be smarter to sell the house, if possible.
  • If you're too far behind or too underwater, going into a foreclosure or short sale might be the better option. "If you're delaying the inevitable and it's unlikely you're never going to reach that [equitable] value again, or take you forever to pay it back, you may be better off to cut the ties," says Jaime.
  • How much does the refinancing cost, and how long will it take to break even?

But if you can just lower your rate for a one-time fee, you're in the clear. It's cheaper than a refinance, and if you're moving in the next few years, just calculate your break-even point.

For example, let's say a modification on your $250,000 30-year fixed-rate mortgage lowers your interest rate by 1%, dropping your rate to 5%. That would save you $157 a month -- $2,512 total -- and you would break even in 16 months. If you were going to move before then, it's not worth it.

Now let's say you want to refinance using the same example. But since closing costs are involved, it'll take you $5,000 to reduce your interest rate. You'll still save $157 a month, but it'll take 32 months to break even. But if you want to write someone out of the mortgage or change the loan type, this could be your only option.

Bottom line? Ask your lender. Call and see if it can reduce your rates and about what modifications or refinancing options it can offer you.

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