What is a loan modification? How it works and when it can help

A loan modification is an agreement you can make with your lender that may permanently update your loan terms if you are facing financial hardship. Loan modifications can happen for many types of loans, including student or auto loans, but for the purposes of this article, we will focus on mortgage loan modifications.

If you receive a loan modification, your monthly payments could be adjusted if you can demonstrate you’ve encountered significant financial hardship. Lenders are not obligated to provide loan modifications, but they may work with you to find a solution if it can help you avoid foreclosure.
Lenders will review your finances, including your credit history, debt, and income, to see if you can keep up with your payment schedule.
When a loan modification goes into effect, your loan can change in the following ways:

• Extra payments – Your lender may extend your total repayment period by months or years to help bring your loan current.
• Changed interest rate – Lenders may change your initial interest rate or convert your adjustable-rate loan to a fixed-rate loan.
• Principal forgiven – In some scenarios, lenders could lower or forgive your loan principal, but this rarely happens. Forgiving your loan principal could be considered taxable income, so be sure to work with a tax professional to understand the implications if your loan is modified this way.

Loan modifications may be available for all mortgage loan types, but availability will vary depending on lender and loan standing.

• Conventional loans – Loans offered through Freddie Mac or Fannie Mae may offer flexible modification programs that may extend your loan term, which may result in more interest paid over time.
• FHA loans – The Federal Housing Administration offers both loan modifications and partial claims, which take past-due payments and put them in a zero-interest second mortgage.
• VA loans – To qualify for a loan modification with the VA, your loan must be in default. Oftentimes, the VA will require you to re-amortize your loan, which starts it over on a new payment schedule.

Each lender will have their own eligibility criteria for a loan modification. Qualifying circumstances that demonstrate financial hardship could include:

• Death of a spouse and loss of their income
• Divorce (and loss of spouse’s income)
• Long-term illness or disability
• Loss of property due to a natural disaster

Some lenders may require that a homeowner has missed a mortgage payment or has a high likelihood of missing a payment to qualify. Talk with your lender before applying for a loan modification to understand their qualifications.

If your lender does not think your situation demonstrates proof of financial hardship, you may be disqualified from receiving a loan modification. Lenders will review your overall financial situation, including your total debt and other factors, when deciding whether you are eligible.

According to the Consumer Financial Protection Bureau, you can file an appeal within 14 days of receiving notice that you did not qualify for loan modification. You can use HUD-approved housing counseling agencies at little or no cost if you need assistance working with your servicer or loan provider.

• Research your options – Talk with your lender to understand your options and provide them with more information about your circumstances. Depending on your situation, your lender may propose a different plan if you are encountering a financial hardship.
• Gather documents – Lenders will review financial documents as well as documents that can give them a better sense of what’s causing your financial hardship, such as a death certificate, divorce paperwork, etc.
• Submit application – Once you have had a conversation with your lender and submitted the correct documentation, complete and submit your application.
• Next steps – If you are approved, review your updated loan terms and understand your expectations. Your lender may require you to make trial payments before the loan is formally modified. If you are not approved, you can file an appeal or work with a HUD-approved housing counseling agency.

If you are a current Wells Fargo customer and facing payment challenges, you can explore potential mortgage assistance options.

Loan modifications can take up to 90 days to process after an application is submitted, but the timeline may vary by lender. Lenders may reach out if they are missing documentation or need further clarity, which could extend the process.

Modifying your loan could cause your credit score to drop, depending on how your lender reports the modification to your original loan agreement.

While there could be a negative impact on your credit score, a loan modification can be better for your credit in the long run if it prevents you from defaulting on your loan or foreclosing on your home. Talk with your lender to understand how a loan modification will affect your credit score.

The Consumer Financial Protection Bureau states that the first notice or filing required by applicable law for any judicial or non-judicial foreclosure process cannot be made unless your mortgage loan obligation is more than 120 days delinquent. If a complete loan modification application has been submitted to the servicer before those 120 days have passed, then no foreclosure can begin.

That said, foreclosure can still occur if the application is incomplete or denied, or if your lender has any specific terms about negotiation or modification in your loan documents. Talk with your lender or with a lawyer to understand your rights to negotiation of a modification.

Some borrowers may pursue refinancing their mortgage loan instead of completing a loan modification. Key differences include:

• How your loan changes – Refinancing replaces your loan with a new mortgage, whereas a loan modification changes the terms of your existing loan.
• Your personal circumstances – Refinancing can be pursued if your payments are in good standing and if you are looking to lower your rate or consolidate debt. Loan modification may be worth considering if you are facing serious financial hardship and at risk of defaulting on your loan or foreclosure.

Similarly, you may pursue a mortgage deferment rather than a loan modification if it works better for your situation. Key details include:

• Payments stay the same, but the loan term does not – With mortgage deferment, you suspend payments for a set period and defer their payment to the end of your loan term. You make the same number of payments agreed upon from your original loan, but the loan term itself has been extended.
• Expected timeline of your personal circumstances – A mortgage deferment may be good for a temporary, short-term problem, whereas a loan modification may be right to address longer-term financial hardship.

Besides the refinancing or mortgage deferment processes outlined above, other common alternatives to loan modification include:

• Repayment plans – Your lender may be able to create a repayment plan tailored to your situation without going through deferment or a loan modification.
• Forbearance – Forbearance allows you to suspend payments or make lower payments on a temporary basis. Since a loan modification permanently updates your loan terms and conditions, forbearance may be an option if you know your situation is temporary. Some lenders may require you to go through forbearance before pursuing a loan modification.

Ultimately, a loan modification has potential benefits and risks to consider as you evaluate whether it works for your situation. Loan modifications may be right for you if you are encountering financial hardships and can show your lenders your intent to avoid defaulting or foreclosure and to keep your payments in good standing. If you receive a loan modification, be sure to understand how your loan will change and what is expected of you moving forward.

If you extend your loan term, you may pay more interest over the life of your loan.

If you are a service member on active duty, an eligible spouse, partner, or dependent, or currently receiving SCRA benefits, please consult with your legal advisor prior to seeking a refinance of your existing mortgage loan. In some cases, a refinance may impact your eligibility for benefits under the Servicemembers Civil Relief Act or applicable state law.