Should You Accept an Unsolicited Loan Modification?
Banks have been surprising homeowners with tempting, unsolicited offers to modify mortgages. The proposed loan mods come with attractive terms and a chance to wipe out part of the mortgage balance. But some borrowers find the seeming generosity suspicious.
Some of the offers give borrowers the opportunity to switch from an option adjustable-rate mortgage, or ARM, loan to a fixed-rate mortgage and include partial balance "forgiveness." They normally don't cost the borrower a penny and require only a signature.
An unasked-for modification may sound like a no-brainer at first. But when you think about the thousands of struggling borrowers who unsuccessfully beg and wrestle their lenders for a loan mod, you may wonder if this offer has a catch or if you're just lucky.
What's the Catch?
Assuming you have confirmed the offer letter came from your lender and not a scammer, there's not really a catch in these loan mods.
But "keep in mind banks are not doing this out of generosity," says Howard Ullman, an attorney and owner of Family Counseling Law Firm in Deerfield Beach, Fla. "Yes, you may want to take advantage of (the loan mod), but it's important to be skeptical and understand what you're doing and why you're being offered this."
Why the 'Generous' Offer?
Take option ARM loans as an example. These once-popular loans allowed borrowers to skip paying the principal and part of the interest on the mortgage for a certain period, while the unpaid portion was added to the loan amount. By offering to modify these loans into fixed-rate mortgages, lenders try to prevent default, Ullman says. But mainly, they try to get these loans off their books because the government and investors view them as "toxic."
That doesn't mean you shouldn't take advantage of the situation. But before jumping on this or any other unsolicited loan modification, borrowers should learn whether the loan mod will affect their credit scores or have tax implications.
Impact on Your Credit
Some borrowers don't realize a loan modification may hurt their credit until months after signing the dotted line, says Norm Magnuson, vice president of public affairs at the Consumer Data Industry Association.
"We've had people call us after they got into a loan mod, and after we talk and they understand how and why it affected their credit, they realize that what they were really looking for was a refinance, not a loan mod," Magnuson says. "Loan modifications do help you out, but you probably are not going to be happy with your credit results."
But every rule has exceptions. Depending on how your lender reports the modification to the credit bureaus, your credit score might remain intact if you are current on the mortgage.
That's why it is crucial to discuss the details with the lender beforehand, Magnuson says.
Ways to Avoid Hurting Your Credit
To protect your credit in a loan modification, avoid trial periods, especially if the modification reduces your monthly payments.
In general, borrowers who are required to go through a trial period before getting a permanent modification run the risk of hurting their credit if the modification reduces their monthly mortgage payments. That's because lenders report the payments to the credit bureaus as if the borrower has been paying less than the amount owed.
Lenders say most of these voluntary modification offers, especially those for option ARMs, don't require trial periods. Ask.
If the modification involves "principal forgiveness," and the lender reports your account as "settled for less than the full amount due," that can negatively impact your credit and remain on your credit history for seven years, says Barry Paperno, consumer operations manager for FICO.
But if the lender just reports the loan as modified and updates the principal balance, these changes alone should not affect your credit. That's assuming the lender keeps the modified loan under the original account number, and the report doesn't include any special comments that could be considered negative, Paperno says.
When it doubt, borrowers should ask, Magnuson says. "Have them explain to you how they are going to report this to the credit bureaus."
Tax Implications
Some loan modifications affect taxes, too.
The lender reports principal reductions to the Internal Revenue Service, says Gil Charney, principal tax researcher with H&R Block's Tax Institute. In such cases, the borrower receives a tax form known as a 1099-C. Any amount reported on this form is treated as taxable income that the borrower needs to report, Charney says.
But under the Mortgage Forgiveness Debt Relief Act of 2007, you are exempt from paying taxes on that money if the debt forgiven is on a mortgage backed by your primary home. The exemption is in effect until the end of 2012.
Borrowers who are exempt will still receive a 1099-C form and will be required to include the exemption form when they file their tax returns.
The exemption does not apply to rental properties, vacation homes or second homes, Charney says.
"Unless you qualify for other exclusions, you'll have to pay taxes on that," he says.