How Are Interest Rates Decided When Doing a Modification?

Sometimes, in lieu of refinancing a loan, a borrower will choose to merely modify it. When a loan is modified, it means that the borrower and lender change its terms and sign a contractual addendum to the original loan document. Loans may be modified for a number of different reasons, but often affect the loan's rate of interest. This new rate of interest may be changed based on a number of different factors.

Lender Policies

The single most important factor in changing the interest rate of a loan is the lender's policies. Unlike refinancing, in which a borrower can seek terms from a number of different lenders, when a loan is modified all changes must be done with the approval of the current lender. Some lenders will be willing to make large changes to the loan, while others will only be willing to alter the interest rate slightly.

Credit Score

One of the main factors that can influence the change in the interest rate of a loan is the credit score of the individual seeking the modification. If the individual's credit score has changed significantly since he first took out the loan -- whether it has gone up or down -- then the individual can expect to receive different terms based on whether he is deemed a greater or lesser credit risk.

Prevailing Interest Rates

In addition to a person's credit score, the interest rate that she receives will also be based on the prevailing market rates of interest that other lenders are currently offering borrowers. Interest rates respond to supply and demand, and they can often rise and fall based on shifts in these factors. When a loan is modified, the current climate for loans must be taken into account when determining changes to the interest rate.

Loan Structure

Some mortgage modifications will change the structure of the loan. For example, a loan may be modified so that the rate of interest shifts from a variable rate to a fixed rate, or the payment time of the loan may be extended or shortened. In such a case, changes to the repayment structure could also translate into changes in the interest rate, as the relative default risk for the lender changes, too.