Loan Modification vs. Refinance: Which Is Better?

Trying to choose between a loan modification vs. a refinance? No matter which direction you’re leaning, it can pay to do your research. While there are many variables to consider, two of the most important are whether you’ve missed any payments and your current credit scores. Refinancing may be the better choice if your credit is strong, while a loan modification may be best if you already have, or are in danger of, missing a payment.

Read on to learn how both loan modifications and loan refinances work, their pros and cons, and when a modification is better than a refinance (and vice versa).     

What Are Loan Modifications? 

A loan modification is a change to the original terms of a loan. With a loan modification, you may be able to:

• Get a better interest rate 

• Modify your loan from an adjustable interest structure to a fixed-rate loan 

• Extend the length of repayment (loan term) and, thereby, lower your monthly payments

A loan modification does not replace an existing loan; it simply changes it. Borrowers receive loan modifications through the original lender who disbursed their loan. 

Common reasons for loan modifications include:

• Divorce

• Illness

• Loss of income

• Pandemic or natural disaster  

Loan modifications are most common for secured loans, such as mortgages. However, you may also be able to modify other types of loans, including personal loans or student loans.

What Is Refinancing a Loan?

With a loan refinance, borrowers are actually getting an entirely new loan. The new loan might be from the same lender or from a different lender. With a refinance, you apply for a new loan and then use that loan to pay off your existing loan.

There are a variety of reasons to refinance a loan. These include:

• Lowering your interest rate

• Lengthening or shortening the term of your loan

• In the case of a mortgage, cashing out on some of the equity you’ve built in your home

While refinancing is often associated with mortgages, you can also refinance a personal loan, student loan, auto loan, credit card balance, and any type of bank loan.

Recommended: Personal Loans: The Pros and Cons Explained

Refinance vs. Loan Modification: The Pros and Cons

When trying to decide between a loan modification vs. refinancing, it can help to see how the two options compare side by side.

Refinancing Pros 

There are a number of advantages to refinancing a loan vs. getting a loan modification. Here are some to consider.

Lender Options

When you refinance, you have an opportunity to shop around and compare offers from private lenders to find your best rates and terms. This isn’t an option with a loan modification, which must be arranged with your current lender.

Cash-Out Option

If you have a mortgage and have built up equity in your home, a cash-out refinance allows you to draw money from your home equity to cover outside expenses. The process involves taking on a higher-balance loan and, in return, getting the difference in cash.

Debt Settlement 

If you refinance a mortgage to pay off debt, you may be able to spend less in interest costs. Mortgage rates are typically lower than rates on credit cards, private student loans, and personal loans.

Recommended: What Are Debt Settlements?

Refinancing Cons

There are also some disadvantages to going with a loan refinance over a modification. Here are a few.

Processing Time 

A refinance may take longer than a modification since it takes time to research lenders, send in applications, and get approved. If your loan is close to being paid off, refinancing may not be worth the time and effort.

Qualifications 

A refinance can be harder to qualify for than a loan modification. Because you’ll most likely be working with a new lender, you can expect a fresh analysis of your credit history, credit scores, income, and debt-to-income ratio. If you’ve been struggling to keep up with your current loan payments, it’s possible the terms offered by the lender could be worse than the ones you have with your original loan.   

Prepayment Penalties

Some loans charge a prepayment penalty when you pay the balance off before the term ends. Since refinancing requires that you pay off the existing loan with a new loan, it can be a good idea to check the terms of your current loan to determine whether you’ll be penalized for paying it off early (and by how much) to make sure it’s worth it.

Loan Modification Pros

Here’s a look at some of the advantages of a loan modification vs a refinance.

Faster Processing

Typically, lenders are capable of doing a loan modification relatively quickly — some even in 30 days or less. While loan refinancing can sometimes be faster, you may have a hard time qualifying for a refinance if your income decreased. If you’re looking to modify your loan because you’ve come under financial distress, a loan modification may be the best alternative. 

Loan Principal May Be Reduced

While it's a relatively rare occurrence, there is a chance that your loan officer will reduce your loan principal. This would not be possible with a loan refinance.

You Can Modify a Loan Even if You’re Behind on Payments

One of the biggest benefits of loan modification vs. refinancing is that it’s available to you even if you’re behind on payments. This is because it’s in the best interest of your lender to work with you and prevent a default. With a refinance, you typically must be up to date on your payments to be considered.

Loan Modification Cons 

When comparing loan modifications with refinancing, they also have some downsides. Here’s a look.

Credit Scores 

A loan modification can hurt your credit scores since the lender will likely report it to the credit bureaus. The amount of the drop will depend on your current credit history. Any negative effects on your credit, however, will likely be less severe than the impact of a string of late payments or, worse, a foreclosure.

You Can’t Switch Lenders

Only your existing lender can offer you a loan modification. With a refinance, you can shop around and choose to work with a different lender.

You May Need to Show Evidence of Hardship

Lenders have no obligation to accept your request for a modification. As a result, getting a modification can be more difficult than refinancing. You'll likely need to show evidence of hardship, and every lender has its own standards when it comes to who qualifies for a modification. 

Is a Loan Modification or Refinance Better for Your Credit?

Does refinancing hurt your credit? How about a loan modification? Both options can impact your credit. However, a refinance will generally affect your credit less than a modification.

When you refinance, you’ll be subject to a hard credit check. This can lower your credit score by about five points. While the drop is only temporary, and your score will likely bounce back within a few months, it could be an issue if you are looking to buy a car or rent an apartment in the near future. In the long-term, however, making on-time payments with your new loan can ultimately help you build credit.

Loan modifications can also have a negative effect on your credit. When you receive a loan modification, a comment code will typically appear on your credit report that says something along the lines of "paying by modified terms."

However, if you're thinking about a loan modification because you’re behind on payments, chances are your credit has already taken some hits. If a loan modification helps you get back on track with payments, that can help you build (or re-build) your credit profile and, ultimately, make up for this derogatory remark.

The Takeaway 

But before you jump at the chance to modify or refinance a loan, it’s a good idea to consider all the angles.

A loan modification changes the terms of an existing loan. It’s a good option for anyone already behind on payments and, in the case of a mortgage, may help prevent a foreclosure. 

A refinance, on the other hand, replaces your existing loan with a completely new loan. This can be a smart move if you’ve built your credit or rates have dropped since you took out the original loan. When you refinance, you may be able to lower your interest rate, reduce your monthly payments, and/or change your loan term. 

If you’re interested in refinancing with a personal loan, Lantern by SoFi can help. With our easy-to-use online lending tool, you can access personal loan offers from multiple lenders with just one application.