Three years ago the term “loan modification” was practically unheard of, especially in the mortgage environment.  Today, however, the term is almost as common as “refinance” and “home equity loan”, and that’s not necessarily a good thing.  This week we’ll explore the loan modification option, as well as its credit downside. 

A mortgage loan modification, hereafter “loan mod”, is the process whereby your mortgage lender will either temporarily or permanently modify the terms of the mortgage loan so you can continue to afford their payments and thus stay in their home.  A loan mod can be as simple as a reduction in the interest rate or as extensive as a reduction of the balance owed.  Either way, the net result is a lower payment for the homeowner. 

The primary government program used to facilitate loan mods is HAMP (Home Affordable Modification Program), which is part of the Making Home Affordable program.  The prospect of reworking the terms of your mortgage loan to make the payments more affordable sounds like a fantastic option for struggling homeowners.  However, there is a significant credit downside to even attempting to modify your home loan.

When you apply for a loan modification it’s just that, an application.  The lender decides whether or not you qualify for a modification based on your personal situation including what kind of hardship you’re suffering.  Point being, you may think you have a hardship significant enough to warrant a loan mod but the lender may disagree with you.  But, of course, neither of you will know this until you apply for the modification. 

If you do choose to apply then you’ll likely be asked to make a lower payment than normal during a “trial payment period.”  It’s unknown what the logic is behind the lower monthly payment other than to prove to the lender that you can successfully pay less than you’re currently paying.  The problem with these lower payments is that they don’t satisfy your monthly minimum obligation.  This means late payments will be reported to the credit bureaus and you will start to incur late fees.  And finally, each month your loan will become further and further past due.

The trial payment period is supposed to last only 3 months, which is more than enough time to process a loan mod application.  The problem is many loan mod applications are taking 6 to 9 months to process because of workforce reductions over the past 3 years.  This means your lower (and late) payments will persist the entire time your trial period lasts.  All the while these late payments are driving your credit scores further and further down or locking in already low scores for seven more years.    

If your loan mod application is denied you will be asked to immediately bring your payments current.  This will include all balances in arrears plus late fees.  This will likely be thousands of dollars because of the length trial period.  If you’re unable to bring your payments current your lender will begin foreclosure proceedings.  And, of course, all of this will be reported to the credit reporting agencies for years to come. 

The bottom line about loan modifications is that the hypothesis is solid.  Lower payments should equal fewer defaults and more families remaining in their homes.  However, the execution of the plan has so far been very poor and consumers and their credit reports and scores have been caught in the middle.

Next up… The Downside to Short Sales     

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry.