Comparing the Costs of Loan Modification and Short Selling

Both loan modification and short selling are loss mitigation tactics when a borrower can no longer afford mortgage payments. Both offer ways to keep a mortgage from going into foreclosure. They are not easy processes, and they can end up costing both the borrower and the lender money. However, in the long run, they offer savings over allowing a foreclosure or default to occur.

What is Loan Modification?

Loan modification is renegotiating a loan contract to make it more favorable to the borrower. In this case, loan modification is being pursued as a means to prevent default. This usually means extending the mortgage over a longer period of time to reduce payments. Modification can also mean staying payments on the mortgage for a period of time, called deferment, or stopping foreclosure proceedings while a borrower gets current on sums owed, called forbearance.

When to Modify?

There are several costs to modification. One is typically a higher interest rate assessed over time. This means the borrower goes further into debt in the long run. It also can mean the borrower loses some equity in the property in the short run. In addition to these costs, there may be a one-time fee for modifying the loan. This fee typically covers the cost of adjusting the contract. Basically, it is a fee given to the lender in exchange for the time and effort spent renegotiating the loan. If a borrower chooses to refinance a mortgage by taking a new loan from another lender, more fees will result. These fees include a penalty for prepayment with the existing lender and a credit penalty for breaking the mortgage contract.

What is Short Selling?

Short selling is slightly more complicated. Both parties, the borrower and the lender, have to agree to short sell a property before the process occurs. The lender agrees to accept the payment the borrower can secure through the sale as the full settlement on the mortgage loan. This sum is typically less than the borrower still owes on the loan. The lender will only be willing to accept this arrangement if a short sale saves money over a comparable foreclosure. 

When to Sell?

Short sales should only be used when foreclosure is inevitable. Both parties lose money in a short sale. The borrower loses because they do not gain any benefits of equity and growth in the property. A borrower should also be aware there may be tax implications on any debt forgiven through the short sale process. A borrower may also be responsible for making payments associated with the home's maintenance while the lender attempts to sell the property.

The lender loses because they do not receive a full payment on the loan. However, short sales can save both parties a lot of money as well. Foreclosure fees are high, and the credit impact of a foreclosure can be detrimental. For a lender, foreclosing on the property involves the expense of taking over the home and re-listing it for sale. Even though a borrower is technically responsible, recovering these funds from a borrower who could not make mortgage payments can be impossible.