Loan Modification vs. Refinance. Which Should You Choose?

Fact-checked by Tim Lucas.

Both a loan modification and a refinance are ways to head off trouble if you’re going through tough financial times and are worried about keeping your mortgage. 

But which one you need will be obvious in most circumstances. If you’re acting quickly before your financial distress becomes obvious, you’ll likely want to refinance.

However, if you’re already in trouble and have skipped a mortgage payment or two, a loan modification may be your only way forward.

Key Takeaways

1. Both a refinance and a loan modification can reduce your monthly payments and relieve pressure during challenging times.
2. A loan modification may be your only option if you’ve missed mortgage payments recently.
3. Loan modifications can lower your credit score, which limits borrowing options in the future.
4. Refinances work best when your new mortgage rate is lower than your existing one. But you might still benefit even if it’s going to be higher.

Refinancing Is Better For Your Credit

A refinance is likely better than a modification if:

• You’re current on your existing mortgage
• It will lower your payment, providing payment relief
• You can qualify for the new loan

Credit bureaus don’t see refinancing as a negative. It’s a neutral financial transaction with minimal impact to your score.

A modification, however, can tank your credit if the lender reports it as a debt that is settled for less than the agreed amount. More about “loan mods” in a minute.

Your first step is to find out if you can get a refinance and whether it will benefit you enough. At current interest rates, it’s unlikely a refinance will lower your score enough to make a big difference in your finances. The exception is when you have, say 20 years left on a 30-year mortgage, and you extend the loan to a new 30-year term. Your payment could drop even though the interest rate went up or stayed the same, as this table shows.

	Original Loan	Refinance
APR	6%	6%
Loan Amount	$200,000	$167,000
P&I Payment	$1,200	$1,000

Consult a refinance calculator to determine your savings.

Other Potential Benefits

A refinance can boost your household budget in a couple of other ways.

First, if you’re currently paying mortgage insurance premiums (MIPs) on an FHA loan, you could eliminate those by refinancing to a conventional mortgage. But this only works if your loan amount is below 80% of your home’s current value.

Still, MIP can easily cost over $100 per month. So, getting rid of that cost can make a material difference to your finances.

The second way you can improve your household budget by refinancing can arise if you choose a cash-out refinance. With one of these, you borrow more than you owe and take the extra in cash.

You could use that cash to consolidate (pay off) your high-interest debts, such as credit card balances. Or you might spend some on energy-efficient improvements to your home that could cut your monthly utility bills. Either way, you should reduce your monthly costs, helping you to afford your mortgage payments more comfortably. 

Downsides of Refinancing

Closing Costs

Just like with that existing mortgage, you’ll have to pay closing costs, which often come in between 2% and 5% of your loan amount. But you may be able to roll up those costs within your new mortgage.

Closing costs are a drawback to the refinancing option. Loan modification fees are likely much lower than refinance fees.

Also, extending the term of your loan when you refinance means you are borrowing a lot of money over many more years. Meanwhile, taking cash out means you’re borrowing more money over the longer term. 

Each of those will see you pay a much higher sum in interest over the coming decades than a shorter or smaller loan. Still, if you’re facing a financial crisis that could end in foreclosure, you may legitimately not care.

Refinancing Pros And Cons

Refinancing Pros

• Pay less for your mortgage each month through a longer loan term, lower interest rate, or both
• Take out cash to consolidate debts or improve your home
• Does not damage your credit like a loan modification

Refinancing Cons

• A higher total cost of borrowing if you extend the term of your loan (“reset the clock”)
• Bigger total interest bill if you take cash out
• High closing costs
• You may not qualify for a refinance if your credit score has slumped, you’ve missed mortgage payments, or your home is worth less than your mortgage balance

How Loan Modifications Work

Loan modifications tend to be the last resort for mortgage borrowers who have run out of options. They’ve tried everything they can think of, but they still can’t make timely mortgage payments. Nor can they qualify for a refinance

Making Your Case To Your Lender

So, they turn to their lender (the loan servicer to which they make payments) for help. Be aware that lenders aren’t obliged to help. But most will try to assist if you make a strong case.

Explain how a significant life event has undermined your ability to make mortgage payments.

You may well get a sympathetic hearing if you’ve endured an extended period of unemployment, a serious illness or injury, a shortening of your working hours, a bereavement or divorce, the sudden demands of becoming a caretaker of an elderly parent, or something else that reasonably explains your current financial distress. 

If your problems are a result of a natural disaster, you may well get help without it affecting your credit score.

Expect to be asked for proof of what you’re saying and to have to fill in a form or write a letter laying out your case.

Your lender will probably lose money if it has to foreclose on your home, and it would rather avoid that.

However, it won’t want to invest in helping you now if it will have to foreclose in the future anyway. So, you’ll need to persuade it that yours is a deserving case and that you’ll be back on your feet once this bad period ends. 

How A Lender Might Be Able To Help

Lenders have a range of loan modification options that would reduce your monthly payments at least for a while. Federal regulator the Consumer Financial Protection Bureau suggests they could offer one or more of the following:

• Lower your mortgage rate
• Require you to pay only interest for a while, suspending the requirement to pay down your balance
• Add years to your loan term, letting you make smaller payments for a longer time
• Reduce the amount you owe (the “principal balance”)

If your lender offers a loan modification, be sure to review it carefully. There’s no point in agreeing to something that doesn’t realistically address your issues. 

So, if you believe the proposed modification won’t allow you to make timely payments, say so and explain why. Your lender must have limits to the help it can provide. But it should recognize that there’s no point in offering inadequate assistance. 

Pros And Cons Of Mortgage Modification

Pros

• A lower monthly payment — The whole point of a modification
• You’ll keep your existing mortgage at a potentially lower rate than if you refinance
• Helps you avoid foreclosure
• Avoid refinancing closing costs
• Often faster to put in place than a refinance
• Possibility of increasing your equity — But only if you get a reduction in your principal balance

Cons

• Your lender will likely report your modification to credit bureaus, devastating your credit score
• A low score could limit borrowing options or make you incur sky-high rates for several years while you’re rebuilding your credit
• You’ll have to prove your hardship and its causes, and that could mean a lot of paperwork
• You may be required to open escrow accounts for property taxes, homeowners insurance, and the like

When To Consider A Refinance

To get a refinance, you’ll have to qualify for one. And that means meeting the minimum requirements laid down for the type of loan you require.

These requirements include a minimum credit score, a down payment (or equity left in place for a refi), and a maximum debt-to-income (DTI) ratio. You’ll also need to show a steady income stream, probably through a stable employment record. 

The minimum requirements for the most common types of mortgages are:

• Conforming conventional loan — 620 score; 3% down payment; 36%-45% max. DTI
• FHA loans — 580 score; 3.5% down payment; 31%-50% max. DTI
• VA loans — 620-640 preferred score; 0% down payment; 41% max. DTI
• USDA loans — 620 score; 0% down payment; 34% max. DTI

If you qualify for a refi and will benefit sufficiently, you’ll likely prefer one to a mortgage modification.

How To Get A Loan Modification

Plenty of people find a loan modification their only option. 

So, how do you go about getting one? Here’s the normal way:

1. Stop delaying — The sooner you contact your lender, the better. And the faster you respond to its subsequent requests, the sooner they can help.
2. Call the lender — Be ready to explain your situation and have a list of your monthly expenses to hand so you can answer questions. The number is on your most recent mortgage statement.
3. Send in the paperwork the lender needs — You’ll have to prove your hardship (bank and card or loan statements) along with your income and show how the issues arose with evidence.
4. Your lender may send you a special hardship form to complete, or it might ask you to write a hardship letter. Include the required one with your other paperwork.
5. If you receive a modification offer, review it carefully and ask for more help if necessary.

You’ll likely thank yourself later if you devote the time and energy needed to deal with this quickly.

Loan Modification vs. Refinance: Final Verdict

It might take you years to recover from the harm a loan modification could do to your creditworthiness. Some never recover. So, see that as a last resort.

If you can still get approved for a refinance, choose that. But check the figures in your loan estimates to make sure your new mortgage payments do enough to resolve your issues. Otherwise, you still have a loan modification as a backstop.