Loan Modification Defined

by tammy on June 18, 2010

In the most basic sense, loan modification means exactly what it says: it is a modification of the terms of a pre-existing loan. This can relate to any sort of loan and may be initiated by either the borrower or the lender, though as a general rule both parties have to agree to such a change in terms. More specifically, in the United States today, most references to loan modification relate to modifying the terms of mortgage loans in order to help the borrower service the debt more practically.

Borrower initiated mortgage loan modification is almost always detrimental to the lender; therefore many lenders will not even consider loan modification unless the borrower is in serious financial trouble and can properly document this fact. The lender typically has to see loan modification as a preferable alternative to simply foreclosing on the property and reselling it.  As a consequence, any loan modification proposal has to cater to the interests of the lender to the extent required to make it a better alternative. This also ties into the property in question: the more desirable the property, the higher the likelihood that the lender can resell it quickly, making loan modification a less desirable alternative. The amount of the original loan compared to the current value of the property also plays a key role: if the mortgage amount is considerably higher than the current resell value of the property, the lender may be more inclined to prefer loan modification as opposed to investing the money into foreclosure and then reselling the property for a lesser amount.

On the borrower side, the primary goal of loan modification proposals is to bring down the amount owed each month, making the payments more tolerable. The basic standard – set by various housing programs run by the federal government – is that a home is not affordable if the residents have to pay more than thirty percent of their monthly gross income on the payments. As a consequence, virtually no lender will consider a loan modification that seeks to lower the payment below this level. Further the borrower has to carefully document their financial hardship before the lender will consider the proposal.

If the lender agrees that loan modification is a better alternative to foreclosure, the lender will aim primarily at modifying the loan in such a way that the monthly payments are reduced while not actually reducing the overall amount owed. This is typically done by extending the life of the mortgage – its amortization period – which lowers the monthly payment by spreading it across more months. Similar results can be achieved by changing the way the interest is calculated and/or waiving fees, penalties and other additional amounts owed. It is extremely rare for a lender to agree to actually reducing the basic amount owed; lowering the interest rate or reducing the principal, though this has happened on occasion.

It is also very important to note that no lender – even those dealing with the government-sponsored loan modification programs – are obligated to accept the terms of a loan modification. Despite some of the arguments made online about forensic mortgage audits and the like, any effort to coerce or force the lender into a loan modification agreement are likely to backfire completely unless the borrower has the money for a protracted legal battle (in which case he should not be having so much difficulty with his mortgage payment). Therefore it is absolutely essential to approach loan modification on friendly – and mutually beneficial – terms. 

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