Refinance Or Modify While It’s Still Possible

Interest rates have been very low for several years, and right now they are lower than ever, yet millions of mortgage borrowers who could profit from a refinance haven’t.

Similarly, millions of borrowers who are having trouble making their mortgage payments but want to remain in their homes could have their mortgages modified to make the payment affordable but haven’t.

The reasons in both cases probably include apathy, resignation and ignorance, but this article is about ignorance only. I find that many borrowers are even hazy about the difference between a refinance and a modification.

Refinance vs. Modification

In a refinance, you take out a new mortgage, either from your current lender or from a different one, and use the proceeds to pay off your existing mortgage. In a modification, the terms of your current mortgage are changed by your existing servicer, usually for the purpose of reducing the payment.

Most often this involves an interest-rate reduction, but it may also include a term extension and, in some cases, the loan balance may be reduced.

A refinance is a market-based transaction entered into by a lender who wants the new loan. A modification is an administrative measure designed to prevent the costs of a foreclosure. In both cases, however, the borrower must document an ability to make the new payment.

Refinance profitably if you can…

In general, borrowers should refinance if a profitable refinance option is available to them. A refinancing will not drop a borrower’s credit score, while a modification will. Refinancing borrowers can deal with their existing lenders but are free to shop alternatives.

A modification is a lot more complicated, takes a lot more time, and borrowers are wholly dependent on their existing servicers, which means that they have no bargaining power.

Qualifying for a refinance vs. qualifying for a modification…

Declining home values have severely restricted the ability of many borrowers to refinance by eroding the equity in their homes. (Equity is property value less the mortgage balances.) With an important exception noted below, borrowers who have negative equity cannot qualify.

Borrowers with equity of 3 percent to 20 percent can qualify if they purchase mortgage insurance, which in some but not all cases will eliminate the profit from the refinance.

Borrowers with equity of 20 percent or more are best positioned to refinance profitably. In contrast, insufficient or negative equity will not bar a modification.

A low credit score will also prevent a refinance, but not a modification. Because lenders have become extremely risk-averse in the post-crisis market, credit scores have increased in importance and are related to equity.

On a Federal Housing Administration (FHA) mortgage, for example, the minimum score is usually 620, but a 620 score may require equity of 15 percent. If the borrower’s equity is the minimum of 3 percent, the required credit score is likely to be 660.

Borrowers who have suffered income declines to the point where the ratio of housing expense to income is viewed as excessively high will have their refinance applications rejected. However, an income decline of this magnitude will not necessarily prevent a loan modification.

On the contrary, an income decline that weakens the ability of the borrower to continue current payments but still enables the borrower to afford lower payments is the major problem loan modifications are designed to meet.

Borrowers can check on whether they qualify for a refinance using the new qualification calculator on my website.

The HARP exception…

The earlier statement that borrowers with negative equity cannot refinance has a major exception: If their loan is owned by Fannie Mae or Freddie Mac, they are eligible for refinancing under the Home Affordable Refinance Program (HARP). This program was recently extended and liberalized.

The previous negative equity ceiling of 25 percent was eliminated for fixed-rate mortgages; fees were reduced; the requirement for a new appraisal was eliminated in some cases; and incentives were provided to the lenders servicing the loans to refinance them.

Qualifying for a modification…

Determining whether a borrower is eligible for a modification is a complicated exercise on which the rules are anything but clear. The government-supported program, which differs from the strictly private programs, requires that the borrower’s income be large enough to afford a reduced payment but it cannot exceed 3.23 times the current mortgage payment. Further, the borrower cannot have “sufficient liquid assets” to make the payments, whatever that means.

In addition, the owner of the loan must be better off with the modification than without it, which is determined by a complicated algorithm that is available to servicers but not to borrowers or to me. The servicer has the final say.

Ginny:   At the top of the market, I owned three properties: my first home (in a marginal neighborhood, now about 100 percent upside down), my own residence (a big fixer in a great neighborhood), and a triplex I bought as an investment (an OK neighborhood, needed some work, fully rented, but now upside-down by about 30 percent).

When the market turned, I had a couple of bad tenants in my first home and the triplex that set me way back financially, and I was unable to borrow the money I needed to fix the house I lived in. I did a short sale on the fixer, got temporary loan mods on the other two, and moved back into my first home.

Problem is, they’re both so upside-down and don’t seem likely to come back up anything soon. I’m 45 years old and have a great job, but I don’t like the neighborhood I live in now and I can barely ever save anything because these properties — which I thought would help fund my retirement — eat me alive.

Also, I just got word that my loan mod on the triplex is going to expire in January. Should I just sell everything and start over?  Taylor N., Detroit

Taylor:  First, know this: You are not alone. More than 25 percent of home mortgages nationwide are upside-down.

While the majority of Americans have held onto homes with declining and stagnant values in the hopes that the market will recover to avoid locking in their losses, the data is clear on the fact that those who own homes worth less than they owe are the borrowers most likely to fold, short-selling, strategically defaulting or negotiating a “deed in lieu of foreclosure” with the bank.

I don’t think data exists on this point, but I suspect these are the borrowers most prone to give up on the excruciating and prolonged path of home retention efforts the most easily. “Why throw good money, time, energy and emotions after bad?” they wonder.

A few years ago, I would probably have fallen into the cheerleader camp, exhorting “Hang on! Hang in there!” Now, though, going into the fifth or sixth year of this real estate recession, depending on whom you talk to, I’m more jaded and realistic.

As I see it, you have two different scenarios that make up your dilemma, and there are a couple of different ways to think about them. First, let’s limit the scope of our conversation to the situation on the home you actually live in. Next week, we’ll look at the broader constellation of issues you have, including both your residence and the investment property.

My advice to people in your situation is to always go through the preliminary step of getting clear on whether their personal residence still works for their lives as a personal residence.

If you own a home that works well for your life, is affordable and seems like it will continue to be a good fit for your life and your finances in the foreseeable future, I’m generally inclined to advise homeowners to avoid making market-based decisions about whether to continue to hold on to it, whether or not it happens to be upside down.

On the flip side, I’ve seen numerous situations in which families have expanded or shrunk or need to relocate, rendering the upside-down home a serious mismatch. In these cases, it makes sense to more seriously consider whether to divest.

I’d encourage you to ask yourself that question — “Does this home ‘fit’?” — regarding your personal residence. You mention the neighborhood weighs against that finding of fit; you might also be thinking that the neighborhood could prolong the “value recovery” timeline.

Take a more holistic viewpoint and make a decision about whether the home overall still works for your life or not — outside of the context of it being underwater. Whether it does or does not, this knowledge will get you started down the path of cultivating the clarity you’ll need to put a full action plan and decision-making process in place. We’ll discuss what the rest of that plan looks like next week.