What Is Mortgage Loan Modification?

If you're struggling to make your monthly mortgage payment, a mortgage loan modification may be the answer. If your lender is willing, mortgage loan modification can lower your monthly payment, giving you a bit more breathing room. Here, we outline what you need to know before requesting a mortgage loan modification.

Unlike refinancing, which essentially replaces your current mortgage with a new one, a mortgage loan modification changes the terms of your existing loan. Mortgage loan modifications are designed to make payments more affordable for those who are facing financial difficulties. Whether you have a conventional, FHA, or VA loan, you should be able to find loan modification options to fit your loan type.

The downside of a mortgage loan modification is that lenders may report it to credit bureaus as debt settlement. If they do, your credit score will take a hit. Still, debt settlement is less damaging than a foreclosure. If you suspect foreclosure is on the horizon, it's good to know you have at least one other option first.

While this list is not exhaustive, here are some of the ways lenders might modify your loan.

Extended loan term: Mortgage lenders will sometimes offer to extend the period you have to repay the mortgage loan. Let's say you have a $300,000 mortgage with a 15-year loan at 5.50% interest. Your monthly mortgage payment on principal and interest is $2,451. If the lender extends the loan to 20 years, your new monthly payment would be $2,064 -- $387 less.

Of course, because you are paying over a longer period, you will end up paying more for the loan overall (because of interest). Had you kept the 15-year mortgage, you would have paid about $440,000 by the time the mortgage was retired. Extending it by five years means you could pay around $495,000, or $55,000 more. In this case, a mortgage loan modification gave you a lower monthly payment, but cost more due to extra years of interest payments.

Reduction in principal: Reduction in loan principal is the unicorn of the loan modification world, so rare that it is more legend than reality. It occurs when a lender is willing to actually reduce the amount you owe, making it easier for you to pay. Bear in mind that if it does happen, you would still have to pay income taxes on the reduction.

Loan conversion: If the interest rate on your adjustable-rate mortgage is rising too rapidly and you can't keep up, some lenders will agree to convert the loan to a fixed interest rate that you can afford.

Deferment: A deferral (sometimes referred to as "postponement") represents a temporary break from loan payments -- generally for a few months. If you have been a model borrower up to that point, your lender may allow you to skip a few payments. These missed payments would then be added to the end of your loan.

Lower interest rate: This is probably the most common form of loan modification and can be permanent or temporary (see below). Even a drop of half a percentage point can make a difference: You'd pay $1,703 a month toward principal and interest on a $300,000 30-year mortgage at 5.50%. If the lender lowers the interest rate to 5%, the payment would drop by $93 to $1,610 per month.

While some lenders offer a permanent reduction in interest rates, others offer a temporary modification that includes a "step-rate" feature. With a step-rate modification, your lender tells you how long your new interest rate will be in effect (typically five years). At the end of that time, the interest rate begins to slowly adjust upward, working its way to what is called the "interest rate cap."

Here's an example of how step-rate modification might work, sticking with that same 5.50% rate: You are offered a modified interest rate of 3.50% for five years, with an interest rate cap of 6.25%. After five years, the rate increases by a maximum of one percentage point each year until it reaches 6.25%. Your mortgage remains at 6.25% for the remainder of the loan.

Borrowers dangerously close to default are prime candidates for a mortgage modification. Financial hardship may include:

• Insurmountable medical bills
• Divorce or separation
• Death of a family member
• Increased living expenses
• Unemployment
• Disability

Before calling your lender, contact a counselor approved by the Department of Housing and Urban Development (HUD). HUD counselors are trained to assess your financial situation and come up with options that will help you make your mortgage payment.

Once you have received professional advice, contact your lender. Explain your situation and ask about loan modification options. Be prepared to provide the following information:

• Proof of income, place of employment, and how much you earn
• Most recent tax return
• List of expenses, including housing, food, clothing, transportation, and other regular expenditures
• Letter of explanation in which you describe what led to your current financial hardship

If your first request for a mortgage loan modification is turned down, do not be discouraged -- the majority of initial applications are denied. Here are some common reasons for denial:

• Your application is incomplete
• You cannot afford the new monthly payment
• Your "hardship" does not meet the lender's standard
• Your debt-to-income ratio is too high
• The lender believes that you can afford your current payment
• You have already been approved for a loan modification (sometime during the past 12-month period)
• You were granted a trial modification period and either missed or were late with a mortgage payment

If your application is denied, submit a written appeal within 14 days. If you are denied a second time, you cannot appeal again, so make sure to provide every piece of evidence requested during the appeal process. Remember, as tough as the mortgage loan modification process may be, it's easier than dealing with foreclosure.

Falling behind on your bills is not the worst thing in the world. You are doing the responsible thing by tackling the problem head-on, and a mortgage loan modification may tide you over until you're back on solid financial footing.

Still have questions?

Here are some other questions we've answered:

• What Is a Second Mortgage?
• What Is a No-Closing-Cost Refinance?
• Mortgage Forbearance vs. Deferment: What's the Difference?