Should I Do a Loan Modification or a Short Sale?

short sale or loan modification
A short sale is often better in the long run than a loan modification. © Big Stock P:hoto

Question: Should I Do a Loan Modification or a Short Sale?

A reader asks: "The value of our home has fallen since we bought it 4 years ago. It's probably worth about one-half of what we paid for it. On top of this, I work for the state of California and have lost 15% of my income due to the state-mandated furloughs. My wife thinks we will qualify for a loan modification, but I've heard horror stories about those. Of course, a short sale isn't much better, is it? Should I do a loan modification or a short sale?"

Answer: This is a difficult question. Whether you should favor a loan modification over a short sale depends, in part, on the following:

 

  • Your financial situation
  • The willingness of the bank
  • Your desire to keep your home

It becomes further complicated if the bank refuses to consider the present market value of your home. If you truly want to stay in your home, regardless of its value, then a loan modification might be the better option.

 

Terms of a Loan Modification

The goal of a loan modification is to reduce a homeowner's mortgage payment and make that payment affordable. This is accomplished by implementing one or more of the following:

 

  • Lowering the interest rate
  • Extending the term of the loan
  • Adding unpaid interest to the principal balance
  • Reducing the principal balance

The Office of the Controller of the Currency (OCC), which regulates national banks, says many loan modifications do not reduce the principal balance owed.

Perhaps more disturbing is the news that a large number of loan modifications soon become delinquent again. It's often just a temporary fix and not a long-term solution.

 

Loan Modifications May Result in an Increased Payment

This may sound bizarre to you and contrary to how a loan modification is supposed to work, but not every bank will offer a loan modification that lowers a homeowner's mortgage payment.

Some banks will offer a loan modification that increases the payment.

Bank use ratios, often capping a certain percentage of your gross monthly income, to determine a new mortgage payment. If the financial statement warrants, the bank may ask for higher payment.

 

Temporary Loan Modifications

Be aware that some banks are offering a temporary loan modification. This means a bank will not agree to make a permanent loan modification but may instead offer the following conditions:

 

  • The principal balance remains the same.
  • Homeowners are asked to make a new reduced payment.
  • The term for the new payment is set for 3 to 6 months.
  • The implication is if the homeowner makes the new payments on time during the temporary loan modification term limit, the bank may grant a permanent loan modification.

However, at the end of the term, the bank is also free to say: "Thank you, very much, for giving us some money, but your loan is now in default." And the bank could proceed to foreclose. I have heard this story from several Sacramento clients who were forced into a short sale by this maneuver.

 

Banks Do Not Process Short Sales Simultaneously With a Loan Modification

Most banks will not open two files at the same time.

You will need to decide in advance whether you want to pursue a loan modification or a short sale. You should chase one or the other.

A bank will close out a pending short sale transaction if the homeowner later decides to try for a loan modification. The length of time to process a short sale versus a loan modification is about the same. Some loan modifications take 3 to 6 months to conclude.

It is unfair to a buyer who has submitted a good faith offer on a short sale and agreed to wait for short sale approval to discover that the sellers have had second thoughts and now want to do a loan modification in the middle of the short sale.

My advice is to make your decision and stick with it. Moreover, do not hire any company to do a loan modification for you because you can request it yourself without paying anybody.

Many loan modification companies are scammers.

 

Why Might a Short Sale Be Preferred Over a Loan Modification?

Homeowners who would prefer to get out from underwater may prefer to do a short sale in-lieu-of a loan modification. A short sale means the bank will accept a reduced payoff and release the loan. If your home is worth dramatically less than the amount owed, it might make more sense to do a short sale and be relieved of the burdened debt.

Here are other factors consider:

 

  • After 3 years of maintaining credit, if prices remain stable, homeowners may qualify to buy another home after a short sale with a mortgage and a payment that is affordable.
  • Both a loan modification and a short sale may affect credit. But either solution is generally better than a foreclosure.
  • Many loan modifications call for an adjustable rate payment than could increase every year after the initial 5 years of fixed-rate payments have passed.
  • Most of the short sale listings I sell in Sacramento involve sellers who were denied a loan modification.

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.