What Is a Loan Modification?

How Loan Modification Works

Lenders are not obligated to provide loan modifications but may do so if you can demonstrate significant financial hardship and that lower payments will help you keep up with your repayment plan. You may also have to show that you've missed at least one scheduled payment on your loan, or that you are about to miss a payment.

When considering a loan modification, the lender will likely review your credit history, other debts, income as well as your other financial resources. If they are satisfied you'd be able to keep up with a modified repayment schedule, they may propose altering your loan contract in one or more of the following ways:

• Extend your repayment period: Adding months or years of additional payments to your loan term can reduce your monthly payments to make the loan more affordable. But it also increases the amount of interest you'll pay over the life of the loan.
• Reduce your interest rate: Lowering your interest rate by a point or more can reduce your monthly payment significantly. Modifications that reduce interest rates may include provisions for "stepping up" the interest rate or monthly payment amount at regular intervals over the remainder of the life of the loan.
• Replace a variable interest rate with a fixed rate: Rate resets associated with variable-rate loans can mean large hikes in monthly payments, and your lenders may offer to convert a variable-rate loan to a more affordable, more predictable one with a fixed interest rate.
• Forgive principal: It seldom occurs, but a lender could lower the principal portion of your loan to ease your payments. Principal forgiven through loan modification may be considered taxable income, so if you're offered this option, you may want to consult a tax professional before agreeing to it.
• Sync payments to your income: Federal student loan guidelines include provisions for payment adjustments that would require modifications on other types of loans. These include income-driven repayment, which adjusts your monthly loan repayments to make them affordable based on your income.

Pros and Cons of Loan Modification

Here's an overview of the advantages and disadvantages of loan modification programs.

Pros of Loan Modification

• Continue making progress paying off your debt: Loan modification allows you to complete payments on a loan you otherwise couldn't afford because of your financial difficulties.
• Long-term benefit to your credit: Although your credit may take a hit in the short term (see below), pursuing loan modification can help you avoid alternatives that would be more damaging to your credit, such as default, foreclosure or repossession.

Cons of Loan Modification

• Greater total cost: Adding months or years to a loan repayment term can increase the amount of interest you'll pay over the life of the loan.
• Could result in missed payments: If your lender requires you to miss one or more loan payments before you become eligible for loan modification (or you miss one or more payments while they're finalizing your modification terms), those delinquencies could do significant harm to your credit score. This is especially true if your payment history is otherwise unblemished.
• Potential balloon payment: Some loan modification schemes call for a lump-sum payment, or balloon payment, to be made at the end of the loan term. Planning for a balloon payment can be challenging, especially if you've experienced a financial setback.
• Loan status: Modification of a loan may cause it to be noted in your credit reports as not paid as agreed, which will tend to have a negative effect on your credit scores—albeit a less severe one than loan default, home foreclosure or auto repossession would have.

How to Qualify for Loan Modification

Each lender and loan servicer has its own criteria for granting or denying modification requests, although modifications on certain government-backed mortgages and student loans are subject to federal eligibility guidelines. Qualifying for loan modification has two components: financial hardship and lender confidence in your ability to keep up with lower payments under the revised loan terms.

To meet the financial hardship requirement, you'll need to show that you've suffered a significant loss of income and/or incurred major long-term expenses. Qualifying circumstances could include:

• Long-term illness or disability
• Death of a spouse (and loss of their income)
• Divorce (and accompanying loss of household income)
• Death of the person for whom a student loan was obtained, if you cosigned the loan
• Loss of property due to natural disaster or other circumstances not covered by insurance

In addition to meeting the hardship requirement, you'll need to show that you'll be able to keep up with payments under a modified loan plan. This will entail a review of your finances similar to one required when applying for a loan. This will likely entail a review of your:

• Credit reports
• Credit scores
• Outstanding debts
• Financial resources, including salary, savings and current or anticipated retirement or disability benefits.

How to Apply for a Loan Modification

Here are steps to follow if you're considering seeking loan modification.

1. Gather Documentation

You'll need to give evidence of your hardship when applying for loan modification, so prepare by pulling together basic paperwork. Requirements may vary by loan type and lender, but you may need to provide:

• Documents that illustrate your adverse circumstances, such as a death certificate or divorce decree
• Evidence of reduced income, such as pay stubs and tax returns, or increased expenses, including bills for home repairs, medical treatment and the like
• Current income documentation for yourself, any surviving co-borrowers listed on the loan and, possibly, other residents you expect to contribute to future mortgage payments in the case of a home loan
• Authorization to perform credit checks on all surviving borrowers listed on the loan
• Current balances in deposit accounts and investment portfolios

2. Research Your Options

If the loan in question is a government-backed mortgage or student loan, criteria for loan modification may be spelled out in federal guidelines. It's a good idea to familiarize yourself with relevant requirements, and to be prepared to address them with your lender. Here's what you could expect with various types of debt:

• Federal student loans: Repayment programs include multiple options for modifying federal repayment terms, including aligning payment amounts with your income and declaring the loan forgiven if you make all required payments for a set number of years, even if a portion of the debt remains unpaid.
• Conforming loans: Conforming loans that meet requirements for purchase by Fannie Mae and Freddie Mac share a program called flex modification that may be available to you if your loan is at least one year old and you are using it to finance your primary residence, and you meet criteria for financial hardship and ability to cover reduced payments.
• VA loans: VA loans, mortgages issued under guidance of the U.S. Bureau of Veterans Affairs, have a variety of loan modification options. Each has its own eligibility requirements, but all require the loan to be in default (90 days or more past due) and that the borrower has sufficient income to pay a reduced payment.
• USDA loans: Available to qualifying homeowners in designated rural zones across the country, USDA loans offer a limited range of loan modification options.

3. Get in Touch With Your Lender or Loan Servicer

Contact the company that collects your payments, which may or may not be your original lender. They may ask you to schedule an appointment later, but it's wise to have your paperwork on hand in case they're ready to discuss your situation immediately.

4. Complete and Submit a Formal Application

Loan modification applications may be available for download from your lender or issued through email or postal mail. You may be able to upload digital copies of supporting paperwork, submit them by postal mail or present them in person, if your loan servicer has a local office.

5. Make Trial Payments, if Requested

After processing your application, which can take 90 days or longer, mortgage lenders may request a series of three trial payments. These will likely be lower than your current payment, but won't necessarily be equal to the amount proposed in a final loan modification offer.

6. If Approved, Do All You Can to Keep Up With Payments

You'll be notified by mail of a final decision on whether to modify your loan; if approved, you'll receive a modified loan agreement and an updated payment schedule. Your credit history may have been bruised in the process, but a loan modification is often a best-case scenario if you're unable to keep up with your current payments.

Alternatives to Loan Modification

If you're facing financial hardship but prefer an alternative to loan modification (or don't qualify for it), here are some alternatives to consider.

• Repayment plan: If you've missed a loan payment or two and are able to resume paying on your regular schedule, your lender may agree to a repayment plan that temporarily increases your monthly payments until you've repaid the amount you missed (plus interest), after which your payments will return to normal.
• Loan forbearance: If you know your loss of income or heightened expenses will be temporary, a loan forbearance plan can reduce or suspend your payments for up to 12 months, after which you must resume regular payments and repay excused payments.
• Payment deferment: Under certain circumstances, payments on federal student loans must be suspended upon request, along with accumulation of interest charges.
• Short sale: If the amount you owe on your house exceeds its market value, your mortgage lender may consent to a short sale, under which it accepts the proceeds from the sale of your home to settle the mortgage. This can be a better option than foreclosure, but may have significant tax consequences.
• Deed in lieu of foreclosure: In a deed in lieu procedure, you voluntarily transfer ownership of the house to the mortgage lender in exchange for release from the loan and payments. If the property is worth less than the balance on the mortgage, you may be required to pay the difference.

FAQ

• What Happens When You Get a Loan Modification?

  If you qualify, your loan agreement will be revised permanently in a way that lowers your monthly payments. The modification will be noted in your credit reports.

• Does a Loan Modification Hurt Your Credit?

  Lenders and loan servicers may report a loan modification as a form of debt settlement. A settlement will have a negative effect on your credit scores until it expires in seven years, but its impact will lessen as time passes. And, once again, its consequences for your credit score will be less severe than if you'd defaulted on the loan.

• Is a Loan Modification Good or Bad?

  On balance, loan modification can be a good thing, despite some potential negative consequences. If you are otherwise unable to keep up with payments on an installment loan, loan modification can help you see the debt through and, if the loan is financing a home or car, do so while retaining the property. Loan modification may do some harm to your credit scores, but its effects will be less severe than those of defaulting on the loan.

The Bottom Line

If you have suffered a financial hardship and need some relief on monthly loan payments, consider consulting your lender or loan servicer about a loan modification. If you qualify, it could make your budget easier to manage while allowing you to avoid the harsh consequences of loan default, vehicle repossession or foreclosure. To track the effects the loan modification has on your credit scores, regularly check your FICO^® Score^☉ for free through Experian.