homeowner calculating mortgage costs

3 Reasons Refinancing Is Better Than a Loan Modification

Regardless of the pandemic, a sudden loss of income can have a devastating impact on a homeowner’s finances. Although mortgage forbearance programs provided some much-needed relief, it may soon be time for them to end and payments to begin. 

Whether you’re struggling to meet monthly payments or want to lock in a lower interest rate, there are two options to consider. There’s the traditional route of refinancing your mortgage or a loan modification. 

It’s not a light decision and one that can significantly impact your financial situation. Before changing your loan terms, keep reading to learn the three benefits of refinancing over a loan modification. 

Credit Score Impact

Refinancing 

While canceling unused services certainly helps, as a homeowner, you have the opportunity to reduce your monthly mortgage payment. Both affect your credit score, but one can make a much more significant impact than the other.

When you submit your application to refinance a loan, lenders conduct a hard inquiry. By checking your credit score and history, you’ll see a slight temporary drop. Even though hard inquiries are visible on your report for two years, they only directly impact your score for one.

In a vast majority of cases, as long as you make your payments on time, it will quickly bounce back and may even surpass the original score. Additionally, if your original loan was in good standing before applying for a refinance, it should lessen the overall impact. 

A common mistake that can create an additional ding to your credit score is accidentally missing payments on the old loan. When refinancing, it can get confusing to remember which payments are due to which lender.

The best way to avoid this situation is to communicate with your new refinance lender. You must confirm their loan payoff arrives before the last payment is due. Overall, the only credit score concern with refinancing is the minimal short-term impact of taking on a new loan. 

Loan Modification and Debt Settlement

Generally, loan modifications are for homeowners facing financial hardships or foreclosure. The requirements will vary with each lender but have the additional condition of proving economic hardship.

While loan modifications come with a hard inquiry, the problem is if the lender decides to report the modification as a debt settlement. Of course, this may not be an issue for some because it has much less of an impact than a series of missed payments or foreclosure.

In some instances, you may be offered a trial loan modification. During the trial, homeowners receive a reduced payment schedule. They have the opportunity to make it permanent if they make three consecutive payments.

However, some lenders may report it as a missed payment because it’s not an official schedule. So while it may sound ideal, you’re at risk of the lender reporting it as a debt settlement in addition to a string of missed payments. 

This can have a significant impact on your credit score, which may be challenging and time-consuming to recover from. If you qualify, refinancing removes this risk and heartache entirely. 

Tax Implications

Depending on the type you apply for, there are some tax benefits with refinancing. And every little bit helps when you’re trying to reduce payments and save as much money as possible. 

For example, homeowners may be exempt from income tax with a cash-out refi in addition to tax-deductible items. 

On the other hand, loan modifications may not be as tax-friendly. There are several ways lenders can modify loans. These include reducing the principal, late fees, interest, extending the loan or a combination. 

If the lender decides to include reducing the total owed amount as part of the modification, then you’re suddenly hit with loan forgiveness. In the eyes of the IRS, you made a profit, and they want a piece. 

The benefit of reduced monthly payments is offset by the fact that you may end up owing a significant sum to the IRS. Fortunately, if you qualify under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude the taxable income.

As with most circumstances involving money, you must understand the fine print. Because of the individual nature of people’s finances, it’s best to speak with a CPA or lending expert for situation-specific advice

Lender Options

In addition to the minimal impact on your credit score and tax benefits, refinancing allows homeowners to shop around for the best rate. 

With interest rates remaining relatively low, it’s beneficial to shop around to negotiate the best loan terms. As mentioned earlier, refinancing involves hard inquiries.

To avoid multiple hits, you can submit several applications within a short window. Most credit score models treat loan applications submitted within a specific timeframe as one inquiry.

Unlike refinancing, there aren’t many options for loan modifications. Because they involve changing the original terms of the loan, rather than taking on a new one, lenders must be the ones to approve the changes.

That means you have decreased negotiating power because you must stick with them. While you may end up with a lower rate, it’s likely not as low as it could have been if you had the opportunity to shop around. 

Additionally, you may not be able to get a loan modification. Most lenders offer it on a case-by-case basis or do not provide it at all. 

Refinancing Your Mortgage vs. Loan Modification

Generally, refinancing your mortgage will provide more economic benefit than a loan modification. In most cases, lenders reserve the latter for homeowners facing extreme financial hardship and are about to lose their homes. 

At the end of the day, these are just two options, and no two households are the same. Contact us today to discuss your financial picture with a team of experts that value your time. 

John has been a Top 3 Nationally Ranked Banker for almost a decade. His experience provided him extensive insight into how best to create an employee-centric environment at Titan Mutual Lending. His work as Founding Partner and CEO will guide Titan to be a leader in the industry, known for compassionate care of its customers. Originally from Connecticut, he currently resides in Arizona, where he has dedicated himself to helping others. John built his path of dedication through both volunteer and Emergency Medicine work.

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