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Financial Implications of Mortgage Loan Modification

The U.S. is in a recession, and this atmosphere has forced many homeowners to face an unfortunate reality: they can no longer to afford their house. And as a result, Americans are deciding to voluntarily let their homes go into foreclosure at an unprecedented rate.

But what about homeowners who are unwilling to let their homes go into foreclosure? For every household that has walked away from its debt, there are untold others that are fighting to continue making their mortgage payments. And fixed income families? A mortgage payment jump or 10 percent or more can be a huge strain. Perhaps one of the most asked questions among struggling homeowners is “why should we keep our home and suffer, when the people that are walking away from their debt are having their slate wiped clean?”

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The good news is that opportunities to change existing lender-borrower arrangement do exist. This would include pursuing a loan modification (wherein the terms of a home loan would be renegotiated) or a short sale (an option where the bank agrees to sell the house for less than what is owed on the mortgage). The latter was created for those who can no longer make their house payments, but, for good reason, want to avoid a foreclosure.

These options exist in effort to help borrowers get out of bad loan situations. It should also be pointed out that both of these solutions are not right for everyone and there will be determining factors for each that will qualify some people for one, and another person for the other. After identifying which category you fit in (based on your financial situation) and also what you would like to do with your home, you will then be able to see if one of these options could be right for you.

Loan Modification

A loan modification, as the name suggests, is a process by which the terms of an existing loan are modified to improve the lender-borrower arrangement to improve the borrower’s ability to continue paying his mortgage. A loan modification is typically initiated by the borrower after their adjustable-rate loan adjusts to a rate that is extremely difficult to sustain. These adjusting loans typically result in monthly payments higher than most borrowers anticipated, creating a legitimate difficulty to make payments. However, with interest rates remaining at historically low levels, many are choosing this option.

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Loan modification involves the borrower negotiating a loan more favorable than their current one, and as a result, most lenders are hesitant to approve this arrangement. If you have decided that a loan modification is necessary for your household, the most important thing to realize is that you will have to make your current situation make sense to your lender. You will also have to get ready for what can be a very lengthy negotiation back-and-forth.

For reference, think of it as trying to get your credit card company to reduce your interest rate, but for hundreds of thousands of dollars.

Another important thing to realize is this: no lender will approve an applicant for a credit loan, if there is any reasonable concern that this person will then later pursue a short sale or a let their home go into foreclosure. Getting approved for a loan modification is similar to getting approved for a home. The key difference is that instead of trying to inflate earnings, homeowners have to be strategic in presenting the current financial situation: it must be stressed that while the household remains solvent, this could change at any time due to certain hardships.

Borrowers will likely want to see a good payment history, and you must communicate to them that there are factors, outside of your control, that jeopardize your ability to continue paying your mortgage at your current rate. Ultimately, the onus will be on you to convince the bank that you are not jumping on the bailout bandwagon – your situation must merit grace, but not absolution.

Credit Implications of a Loan Modification

One great aspect of a loan modification, according to Experian is that your credit will not be negatively affected beyond any late payments (or of course future late payments). Late payments can be overcome over the course of the next year and your credit can bounce back. As a corollary, there are multiple perspectives on when the best time to pursue a loan modification is: while you are still current, or after you are slightly behind. The latter, it has been argued is necessary to effectively prove to your lender that you are experiencing hardship and/or repayment difficulty. Getting approved for a loan modification will require a credit check and other applications, but the fact that a loan has been modified will not be reflected on your credit.

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Tax Implications of a Loan Modification

In December 2007, the Internal Revenue Service (IRS) announced that loan modifications would not be categorized as a ‘prohibited transaction’ in an effort to alleviate the subprime mortgage crisis. This means that most loans initiated during the subprime mortgage heyday (January 2004 to July 2007) and adjusting during its demise (January 2009 to July 2012), would not have be liable to pay income taxes on the difference between the original loan and a later modified loan. Therefore, a loan modification would not require the borrower to file a 1099 on what could be determined ‘income.’

Short Sale Options

A short sale is a program wherein a lender and a borrower agree to sell a house that is on its way to foreclosure, at a price that is below the price of the current loan, so that both parties may minimize their loss. Short sales came about because foreclosures are “lose-lose” situations: if a home goes into foreclosure, then the borrower’s credit is badly damaged for seven years, and the bank loses the difference between the loan amount and the home’s current market value (along with real estate agent commissions and repair costs). If a short sale is negotiated, it is still a “lose-lose,” but arguably a much lesser one. For the borrower, there will be negative credit and tax implications, as the lender trades a big loss for a relatively smaller one. Simply put, a short sale is a way for the involved parties to minimize their losses concurrently.

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If it is determined that a foreclosure is inevitable, then the borrower can use this leverage to convince its lender or “mortgagee,” that a short sale will be the best case scenario for both parties involved. Once a lender agrees to let a house go to a short sale, the borrower can sell the house at a price approved by the bank that is below what they owe. Upon sale, the lender would then relinquish the now former borrower from any and all financial obligation.

It should be noted that a short sale is not likely to be approved, if the borrower shows some wherewithal to continue paying their loan at the current rate. More directly, a short sale would be approved when the borrower’s financial situation suggests that a loan-modification is more trouble than it is worth and likely to just result in default again.

Credit Implications of a Short Sale

Compared to foreclosures, short sales do not negatively affect credit in a uniform fashion. The very essence of a short sale is a lender-borrower understanding that an outstanding debt cannot be repaid. This will not go unnoticed, and while it is not likely to be as serious an impact as a foreclosure, there is no credit report distinction for short sales. Short sale notation does not exist, and every short sale will affect their users’ differently.

There are rare instances in which your lender will not disclose the details of the termination of your loan. In this case, assuming that all preceding payments were timely, there would be only minimal negative impact on your credit score. It is suggested that anyone thinking about short selling their house consider the amount that will be written off, and contact their lender’s loss mitigation department to discuss options and see what their company policy is on this. There may be greater implications depending on the volume of debt written off, and so forth.

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Tax Implications of a Short Sale

The tax implications could be one of the largest determining factors in choosing to go with, or against a short sale, and much has to do with the individual’s tax/income bracket. The person having the debt forgiven is liable for the amount written off, as it is seen by the IRS as a credit towards their net assets. It is therefore taxable as income at a rate that is consistent with their tax bracket. Therefore the costs associated w/ the tax owed on a forgiven loan therefore ranges from person to person.

Finding The Right Option

Deciding which is best for you may be difficult. But the underlying question is “are you looking to keep your house, or are you trying to get away from it?” The most important thing to keep in mind is that both getting approved for a short sale and or a loan modification is in effect getting yourself unqualified for your existing loan. But the determinants and ‘disqualification processes’ for each vary.

Bankruptcy/near bankruptcy: You will not be afforded a loan modification, because a lender could not justify the process if you are expected to soon go into foreclosure. This could help in getting a short sale approved, however. Note, if you are trying to get a loan modification, DO NOT threaten your lender by saying that you have considered declaring bankruptcy. All lenders require their loss-mitigation departments to note any mention of the ‘B’ word as good cause to reject an application for loan modification.

Unemployment: An unemployed borrower is a high-risk borrower. If you have recently been unemployed, wait until you find a new job before you apply for a loan modification under the premise of a hardship. If you can prove that you have become unemployed, your lender will probably approve your short sale instead of letting you go into foreclosure.

Underemployment: If you can show that your work has slowed down, but you are still making your payments relatively on-time, your lender may work out a loan modification, because of your hardship. In fact, this is probably the best time to get a loan modification because you still have an income, but your ability to pay the mortgage is doubly affected by its adjustment and your decreased earnings. You can simply admit to your lender that your employment situation is currently been disrupted. The ball would then be in their court. The same goes for a short sale.

The home has equity: The lender is less likely to work out a loan modification with a borrower if there is equity in the house. They would rather see the homeowner sell the property to get out of the deal.

The home is upside-down: The bank would prefer to work out a loan modification on a house that is worth less than the mortgage balance. If you are in this situation, then you are the ideal customer to retain, as the bank can ideally prevent a bigger loss by having to sell the home through a short sale or foreclosing on the home.

You are current on your payments: Opinions on this vary, and the situation will differ from bank to bank. During your application process you will have to prove your hardship, and a situation such as underemployment may qualify for a loan modification. Many argue that it is best to start this process as early as possible – at the first sign of hardship – because this program takes time.

Past due (30-60 days) on your payments:< Others would argue that in order to qualify for a loan modification you must prove repayment difficulty, which is evident once a payment or two has been missed. However as was mentioned earlier, payment history is taken into consideration, and it would make sense to have a good payment history with a company that you are trying to get to help you out.

Seriously past due 90-120 days: At this point, it is likely that a short sale is your only option. Most lenders would see a vendor at this point as being a customer who will have repayment difficulty in the future, and thus would prefer not to worry about modifying your loan.

Looking Ahead

The most important thing to keep in mind is that certain programs are set up to help different types of people. In other words, not every solution will be the right solution. In order to get the bank to work with you, they have to be convinced that they are minimizing their own losses in the long run. Think of a loan modification as a loan with qualifications that require less than income than your current mortgage required, whereas a short sale essentially means getting disqualified for a loan.

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