The Pros and Cons of 40Year FHA Loan Modifications

FHA borrowers struggling to pay their mortgages to COVID-19 hardships are now able reduce their monthly payments by modifying their loan term to 40 years.

On April 18, The Department of Housing and Urban Development (HUD), which oversees the FHA, added a home retention option to allow mortgage lenders to offer a 40-year loan modification to help struggling homeowners. According to a press release, mortgage lenders must make this option available within 90 days but can begin offering it immediately.

“Over the last year we have made substantive changes to our COVID-19 recovery options that are showing strong results in helping homeowners with FHA-insured mortgages recover from the devastating financial effects of the pandemic. Adding a 40-year modification with partial claim to our toolkit for servicers today reaffirms our long-term commitment to continue helping as many struggling homeowners as we can to keep their homes,” said Principal Deputy Assistant Secretary for Housing and the Federal Housing Administration Lopa P. Kolluri.

While the current 40-year loan modification is part of FHA's temporary COVID relief plan, a permanent version is currently in a public comment period until May 31, 2022. If finalized, it would add the 40-year loan modification to existing help available to homeowners who are struggling with payments.

How it works

Forty-year loans wouldn’t be available to new homeowners. The modification is designed to help current FHA borrowers stay in their homes and avoid foreclosure – before they default on their loans. HUD anticipates the 40-year modification option would “prevent several thousand borrowers a year from foreclosure by increasing a borrower's ability to afford the modified payment.”

That’s because a 40-year term stretches out the time required to pay off the loan, reducing the monthly payment. If you’ve ever compared a 5-year car loan to a 7-year one, you already know the effect a longer term can have on the payment.

The FHA requires a minimum 25% reduction in principle and interest payment in order to qualify for a loan modification, and some borrowers may not be able to do that with a 30-year modification given today's higher mortgage rates. Extending the loan another 10 years may help borrowers reduce payments enough to qualify for modification.

Forty-year loan modifications are already available to conventional borrowers with loans backed by Fannie Mae and Freddie Mac and certain USDA borrowers.

What is a 40-year modification with partial claim option?

Until a standalone 40-year modification is finalized, the current form works in conjunction with the FHA's COVID-19 Recovery partial claim option. The partial claim puts missed payments into a second zero-interest loan that does not require payments until the primary loan matures or is paid off, or the home is sold.

By combining these options, borrowers may be able to achieve a sufficient payment reduction to resume making payments and stay in their homes.

Pros and cons of 40-year loan modifications

During the pandemic, many homeowners fell behind on their mortgage payments due to income loss or sudden health expenses. One way to help them prevent foreclosure and get back on track is modify their mortgage to create a lower, more manageable monthly payment.

Current FHA borrowers can only extend the new loan for 30 years, or 360 months. For homeowners that have only had a 30-year FHA loan for a few years, extending the loan out another 30 years may not reduce the monthly payments very much, especially if the modification comes with a higher interest rate.

But by tacking an additional 120 months to the loan term, a 40-year modification can lower monthly payments even further. According to HUD, this could make the difference between borrowers being able to afford their payments or defaulting and heading toward foreclosure.

But there are drawbacks to extending the loan term so long. Forty-year borrowers would make additional interest payments and build equity at a slower rate. In the long run, they’ll likely end up paying more than they would in a 30-year modification or the original loan. And if they want to sell or cash-out refinance, they’ll have less equity to tap into.

HUD points out that the average life of a 30-year FHA mortgage is around 7 years, so it’s unlikely these long-term drawbacks would have much effect on most borrowers.

If enacted, the 40-year loan modification will be a specialized tool that can help certain borrowers get back on their feet – not a magic hammer that can smash all FHA loans into better shape.