Lender Secret Now Leaking Out

There's something lenders don't want to tell you, a little secret that can save homeowners thousands of dollars.

It works like this: Rates have fallen and you want to refinance a fixed-rate loan. You contact your lender and discover that because you're a great and wonderful person and all your payments have been full and timely, you're qualified to refinance. New papers will be required, and that will mean a new closing, legal fees, survey, appraisal, and perhaps a bunch of taxes.

What lenders don't say is this: You may be able to refinance without the need to fill out 900 forms or pay big closing costs.

For instance, several years ago rates were down and I needed to refinance an investment property. I called the lender and said, "let's modify the loan."

I exchanged letters with the lender setting out the new terms. My attorney looked at the letter, the lender accepted, and that was it. Total cost: about $35.

What really happened was this: The property was not refinanced. Instead, the loan terms were modified. Because the terms of an existing loan were changed, there was no need to record a new loan. Since there was no new loan, there was also no need for a new closing, title search, or smaller checking account.

None of this is especially revolutionary. There are millions of adjustable rate mortgages and the terms for such financing change constantly with new rates and payments. When these changes are made, no one refinances. The terms change because both lender and borrower have agreed that the loan provisions can be modified.

We now have lenders who have gone public with ARM products where the initial rate is also the highest rate. If interest levels drop, the loan rate also falls.

Given the choice of an ARM where rates can rise and fall, or an ARM where rates can only fall, you can bet that few consumers will opt for the greater risk of possibly higher rates -- unless lenders want to make such loans attractive with significantly easier qualification terms, lower rates, and fewer costs.

But while the modification "genie" is now somewhat out of the bottle, there is more to go.

Not only can new ARMs be modified, so can millions of existing loans whether they are ARMs or fixed-rate products. If lender and borrower agree, loans terms can be changed to whatever might be mutually acceptable.

So the next time you get the urge to refinance, stifle that feeling and think "modification." Increasingly, lenders will welcome such thinking -- or lose your business.

Question: I borrowed $100,000 several years ago and would now like to increase the loan amount to $150,000. Can a loan modification work in this case?

When a loan is recorded there's typically a tax based on the mortgage amount. Thus if a loan is modified and the interest rate, monthly principal, and loan length are changed, there is no event to tax. But if the mortgage amount increases above the original principal, then a state government will likely see "new" financing and something to tax.

A second reason that loan amounts likely cannot be increased with a modification is this: Suppose a home has two loans, a first loan used to acquire the property and a second mortgage, perhaps a home equity loan. In this case, if the size of the first loan increases, the security of the second lender declines.

When a home is foreclosed all money is used to pay off the first loan holder. Any remaining money is used to settle the claims of the second lender, and then the third lender, and so on. If there is little or no money left over after the claims of the first lender have been satisfied, the other lenders lose.

If we increase the size of the first mortgage, we also unfairly increase the risk of any second or third lender.

Question: I can refinance with no closing costs so why should I look for a loan modification instead?

There is a difference between "no closing costs" and "no costs." In your situation, the lender is paying your closing expenses. The lender must get that money from somewhere, and that "somewhere" is your loan in the form of a somewhat higher rate than might otherwise be available, a larger loan amount, a prepayment penalty if you quickly refinance, and perhaps all three.

Question: My lender will allow me to modify my loan, but only if I get a new appraisal. Why should I pay this cost?

Because it's not unreasonable, it's cheaper than refinancing, and it assures the lender that the property has sufficient value to justify continuing the loan.

Question: If a borrower can ask for less interest when rates go down, why can't lenders ask for more interest when rates go up?

They can -- and you can say "no."

The goal of the lender is to make more loans and generate more income. The goal of the borrower is to have less debt with less cost.

The reason for a lender to accept a loan modification request is to continue the loan and the stream of interest and servicing revenue it represents. If a modification request is not accepted, perhaps you'll refinance elsewhere.

Borrowers have different motivations, and since a fixed-rate loan agreement is in place and favorable to them in a rising market, consumers have no incentive to accept higher rates -- unless a lender would like to make some concessions.

Question: Other than money, why do lenders prefer "refinancing" rather than a loan modification?

Replacing an existing loan with a new mortgage can substantially impact lender risk. For example, if you live in California and buy a home with a new loan, your financing is generally considered a "purchase money mortgage." If you're foreclosed or go bankrupt, the lender gets back the house but cannot sue you for any shortfall. However, if you "refinance" you no longer have a "purchase money mortgage" and a lender can seek a deficiency judgment if you're foreclosed.

Question: I have a lender who will agree to a mortgage modification. Do I just write them a letter to create the new terms?

You want your attorney to review any proposed loan changes before signing anything.

Question: Are loan modifications a new concept?