By: Jack Guttentag
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. 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.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania.