Loan Modification and the Effect on Your Credit Score

by Kevin on December 7, 2009

This is a guest post from Jon. Jon is behind the Hardship Letter Sample site and wants to help you avoid foreclosure.

Millions of Americans are applying for and receiving loan modifications. The question of what affect these modifications have on their credit score doesn’t always get carefully considered. The bottom line is that a loan modification will affect your credit score. Yet as with most things in life the answer is a little more complicated than simply stating it will affect your credit score.

The main issue with loan modifications is that the lender typically won’t issue one unless you are already late on your payments.

The theory is that once you are late on your payments you will have more leverage over your lender since you are a higher risk for defaulting on your mortgage unless you receive a loan modification. By not paying your mortgage flags go up at the bank for default. Since you are late on your payments your credit score will begin to go down.

All this being said the impact a foreclosure or bankruptcy would have on your credit score is orders of magnitude worse than the damage of late payments and a loan modification.

Ultimately the decision is on a case by case basis. Here are four general scenarios that may help you decide whether a loan modification is right for you and your family. All four scenarios below assume serious financial troubles whether be it a job loss, law suit, or overwhelming medical bills.

Loan Modification Scenarios

1. Good Credit – Late On Payments

Since you have a good credit score and are already late on payments your credit score will only be marginally damaged with a loan modification (especially when compared to a long period of late payments or foreclosure).

2. Good Credit – Not Late On Payments

Based on these circumstances it would be best to pursue other options of reducing your mortgage payments such as refinancing (also known as a remortgage). If you fall behind on your payments than you will fall into group 1 and should consider a loan modification.

3. Bad Credit – Late On Payments

You are the group that would most benefit from a loan modification.

To the bank you are considered a high risk borrower with a high risk of foreclosure. Since every foreclosure costs the bank a lot of money they have additional incentives to give you more favorable loan modification terms. If you are in this category I highly recommend looking into a loan modification. If you receive a loan modification and can begin to repay your loan on time your credit score will begin to climb.

4. Bad Credit – Not Late on Payments

If you are in this situation your ability to refinance is not ideal. The mortgage company will not consider your mortgage a high risk loan and will be less willing to offer you a loan modification. If you feel your situation is dire enough that it is only a matter of time until you become late on your payments than I suggest you look into the loan modification process.

How to begin the loan modification process?

There are several steps in the loan modification process, I will briefly summarize them for you here:

First Step – Determine if you qualify

Here are the guidelines to qualify for a “Home Affordable Modification” also referred to as an the “Obama Loan Modification”.

  • You must live in your home (show proof with your tax return, utility bill, or other documentation such as a credit report)
  • Your home cannot be condemned or vacant
  • Your current mortgage amount must be within the Fannie Mae limits for loan modification help ($417,000 and in high cost areas $625,000)
  • Your current mortgage payments must be more than 31% of your gross income (the goal of the loan modification program is to modify your loan so that your payments will drop to 31% or below)

Second Step – Draft and Submit a Hardship Letter

A hardship letter is a well written letter that explains what event has occurred that has forced you to fall behind on your mortgage payments. The hardship letter is the most important document in the loan modification package since its your first contact with your lender regarding a loan modification. Some common “hardships” that lenders are accepting include…

  • Job Loss
  • Income Reduction
  • Spouses Death
  • Incarceration
  • Business has gone bankrupt
  • Medical Bills
  • Military Service
  • Other…

Not sure how a hardship letter should read? Here is an example letter that has worked for others in similar situations.

Third Step – Request and Complete a Loan Modification Kit

Once you have made contact with your lender you need to request a loan modification kit. It will include all the information that your lender is looking for in the loan modification package.

You need to take their requests seriously as you fill out the package. An incomplete or incorrect modification request shows carelessness. This is a serious issue; therefore you must show your lender your understanding of the situation.

Of course any loan modification request submitted with only partial information will not be accepted.

Fourth Step – Negotiate and Sign Your Loan Modification

This is the final step in the loan modification process. The final step is often overlooked and many mistakes can happen during this stage. For example, one homeowner emailed me her loan modification form she had just signed. It had a reduced rate for 6 months and then jumped back up to 12% which was higher than her pre-modified rate. Some lenders will use tricks like this to only put you further behind, make sure to read and understand the terms you are agreeing to.

In the end, a loan modification may be the right decision for you and your family. But make sure you consider the impact a loan modification will have on your credit score.

{ 1 comment }

Laura from December 8, 2009 at 11:58 am

Great advice, in a way its a no win situation when you find yourself in that situation

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