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Home Loan Modifications: How They Work

Home loan modifications aren’t as common today as they were just a few short years ago.

Loan modifications have in fact been in existence for decades yet were rarely used. What is a home loan modification and what are they used for? Even though their popularity may have dwindled as markets have stabilized and property values recovered but in the right situation a home loan modification is a financial tool available to some homeowners when they wish to change certain aspects of their mortgage loan.

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As the housing market began to deteriorate around 2007 and 2008, millions of homeowners refinanced their existing home loan as rates in general began to fall. When the Federal Reserve lowers the Federal Funds rate, the rate banks charge one another for short term, overnight loans, interest rates in general typically follow suit. Mortgage rates were included in that fall. Lowering interest rates lowers the cost of money which in theory leads to more consumer spending, helping to boost the economy. Mortgage rates continued to fall until they reached historic lows back in November of 2012.

Yet while millions of homeowners were able to refinance many more were not. Why? Because they owed more on their mortgage than the property was worth. Most refinance guidelines ask there be at least a 10% equity position, meaning the loan balance should not exceed 90% of the property’s current appraised value. When borrowers are “upside down” they can’t refinance due to this 90% guideline. But they can modify a loan which may reach the same goal.

Modification Mechanics

When you take out a mortgage one of the more important documents you’ll sign is your note. The note lays out the terms of your loan including your interest rate, how much you’re borrowing and the term of the mortgage. If you have an adjustable rate loan the note will identify the index associated with your mortgage, the margin and interest rate caps. This can’t be changed. The note is “forever” and the only way to change the note is to replace the note with a new one. That is unless your lender agrees to a loan modification.

A loan modification isn’t an automatic. You have to make the case for a loan modification that the lender will agree to. If, after a review of your loan modification request, the lender agrees to modify your note, your request will be granted. However, if the lender does not see a valid reason why a note modification is necessary, it’s likely your request will be declined. The lender should be convinced the only other option is to foreclose on the property, something lenders are loathe to do.

Let’s consider a couple who have had a mortgage for a little less than three years and they both work. One spouse gets laid off and after six months the former employer closes down completely. The spouse cannot find work and they see their savings account dwindle. They have a hybrid mortgage, a 3/1 variety, and it appears once the initial adjustment takes place the monthly payment will be well out of reach. Instead, they contact the lender and apply for a loan modification to a lower, fixed rate that fits the new, lower income of the couple. The note is changed reflecting the modifications and the owners keep their home and the lender continues to collect monthly interest.

It’s not always the borrowers that request a home loan modification however. When borrowers begin to fall behind on their payments the lender and reach out and offer a loan modification as a short or long term alternative. If the borrowers agree, they can complete a formal loan modification request. A loan modification can not only change the rate on the note but also extend the term of the loan. A longer loan term will lower the overall monthly payment. For someone with a 30 year loan the lender might offer to modify the note to a 40 year term. A lender can also agree to take all the past due amounts and add them back into the loan. Or, the lender can simply forgive a portion of the outstanding balance and lower the loan amount.

But a loan modification needs to be carefully considered and should only be used as a way to avoid a foreclosure. When a loan modification is recorded, it will appear on a credit report as well as a public record. That can impact the ability of obtaining a mortgage in the future.

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Financing After a Modification

If a modification is recorded there are also recent late payments that appear. Remember, the lender must be convinced a home loan modification is necessary and late payments are almost always evident. A modification doesn’t quite have the negative impact a short sale or a foreclosure has but it is still a mark. A mark that is recoverable but a mark nonetheless. A modification tells a lender they want to keep the home and avoid foreclosure instead of just walking away from the loan and property altogether.

Home loan guidelines don’t have any specific waiting periods such as a waiting period for a bankruptcy or a foreclosure. However, conventional loans underwritten to Fannie Mae guidelines do have a restriction and ask that at least two years pass before approving a new loan. Freddie Mac has no such waiting periods nor do the government-backed programs of VA, FHA and USDA.

However, just because the guidelines don’t have a waiting period that doesn’t mean individual lenders won’t either. Lenders have the authority to issue additional loan approval guidelines beyond what Fannie, Freddie or any government-backed loan says as long as the additional guidelines are applied equally to all applicants. Such additional guidelines are referred to as lender “overlays” and lenders may in fact have an overlay of a waiting period after a home loan modification. What that means to borrowers is just because one lender requires a two year waiting period on a particular loan doesn’t mean all lenders have the same requirement.

Finally, to obtain financing after a home loan modification, it’s critically important there be no new negative credit after the modification has been recorded. There should be no more late payments, especially on the modified note, on any credit account that appears on the credit report. A home loan modification is an answer to a changed status of the borrowers on the note and used to help borrowers out of a bad situation.

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Chad Baker, CrossCountry Mortgage   
NMLS# 329451 | CCM NMLS# 3029