Pitfalls to Loan Modifications

ARE THERE DOWNSIDES TO LOAN MODIFICATIONS?

The simple answer is it depends on your situation as the negatives may not outweigh the advantages of lowering your monthly mortgage payment in the first place. A loan modification, according to loanmortgage.com, is when a lender agrees to modify the terms of a mortgage to make it more manageable for a financially stressed homeowner. It may involve reducing the interest rate, extending the term of the loan, restructuring the payment schedule or other adjustments. While the definitions and purposes of a loan modification sound great, there are still some things borrowers should be aware of, in order to avoid potential pitfalls and know what to expect out of the process itself.

The potential negatives of a loan modification are as follows: may restructure to a more expensive loan, modification may negatively affect your credit, and the modification may end up making your situation worse.

MORE EXPENSIVE?

Logic would tell us that a modified loan means that the homeowner in distress should wind up having a reduction in their loan. But does it always happen this way? According to the Office of Comptroller Mortgage Metrics report of April 2009, "... only 41.85 percent of all modifications reduced monthly principal and interest payments for homeowners. For delinquent borrowers - - a loan modification resulted in an INCREASED or EQUAL payment amount 58.15% of the time!!" These are more accurately described as payment plans, since they're designed to bring a past-due account current by spreading out the delinquent balance over time, on top of the regular payments, but nonetheless, many lenders describe them as loan modifications.

Private loan modifications may also involve such measures as extending the term of the loan, say out to 40 years instead of the 24 the borrower currently has remaining. While this can reduce the monthly payment and be helpful to a homeowner in a tight financial spot, it does increase the interest payments and overall cost of the loan over time.

DAMAGE TO CREDIT?

Many homeowners who are upside down on their mortgage may still be eligible for a loan modification due to the asset being in distress, even if they are not delinquent on their payments. Despite staying current on their payments, they still may see a negative effect on their credit score. Many homeowners who obtained trial loan modifications under MHA (Making Homes Affordable) have reported taking a hit on their credit scores of 50-150 points. Some banks report loan modifications as a partial payment on the debt or even as past due (in the case of an MHA three-month trial modification), although reporting practices vary by lender. The industry is supposed to be adopting new credit reporting guidelines to address this problem, but it remains to be seen what effect they'll have.

While this drop in credit can be devastating to homeowners with good credit trying to modify a current loan, the majority of homeowners going through a modification happen to be in default and their credit is already affected. And a temporary drop in credit due to a modification will be better than a drop in credit due to a foreclosure.

WILL A TRIAL MODIFICATION LAST?

Another potential downside that is widely overlooked is that obtaining a trial modification under the MHA program is no guarantee you'll be approved for permanent status, even if you make all your trial payments on time. According to mortgageloan.com, roughly as many completed trial modifications have been rejected as approved for permanent status under MHA, typically because the borrower's income turned out to be inadequate or for other documentation problems.

The shocking part is that the lender may then turn around and demand payment for the difference of the money saved during the loan modification trial period. If the trial period lasted 6 months and the homeowner has been struggling financially, having to repay 6 months worth of savings plus returning to the previous level of monthly payments can expedite rather than prevent foreclosure.

In summary, it is important to remember, a loan modification may not enable you to avoid foreclosure, even after reducing your monthly mortgage payment. Borrowers often adopt a "best-case scenario" when calculating how much of a mortgage payment they can afford on their current income. Unfortunately, those calculations may depend on nothing going wrong, and unexpected expenses or reductions in income can push them right off the fine edge their finances are balanced on. Given the risks of loan modifications, the expense, and the potential damage to your credit, you will want to research your options carefully.