About Restructuring Troubled Debt

All too often, lenders are unaware a borrower is facing a crisis until loans are defaulted and proceed to collections. In many cases, if the borrower approaches the lender and describes the situation in full, the lender will choose to modify the loan to avoid foreclosure. Troubled debt restructuring (TDR) occurs when there is a financial difficulty for the borrower and the bank is willing to change aspects of a loan agreement.

The Facts

Troubled debt restructuring is a service provided by banks or other lenders in which they relax or modify the terms of the loan to help a borrower avoid default. If a borrower is experiencing financial difficulty, he can approach the lender and ask for loan modifications. Although the bank is not legally required to work with the borrower, many will do so to avoid further loss on the loan. The bank is basically choosing to recoup as much of the loan as possible instead of foreclosing on the loan.

History

During national economic trials, banks face tremendous losses because borrowers lose their jobs and wages and can't keep up with their loans. These kinds of loan dealings were common in the late 1980s and early 1990s. Soon after, the economy rebounded and the lending environment was strengthened. During the economic downturn that started in 2007-08, banks returned to the practice of troubled debt restructuring to avoid costly loan foreclosures.

Types

There are many ways that lenders may choose to modify the loan agreement. They may simply reduce the interest rate for the remaining life of the debt, reduce the accrued interest, or extend the loan period to lower the monthly payment. Lenders can also transfer funds from third parties, real estate, or other assets to pay toward the debt. Another type of modification can be granting forgiveness of a part or the entire principal or accrued interest.

Benefits

For the borrower, TDR can prevent painful foreclosures. When borrowers face a financial crisis, they can lose their home, vehicle, and much more. If a lender is willing to work through an agreement by which the borrower can continue to pay on the loan at a slower pace or with smaller payments, it is mutually beneficial. The lender typically loses money in foreclosures, and TDRs can often create more cash flow than the amount that could be collected from a foreclosure sale.

Warnings

If the loan modifications include changes in payment schedules, interest rate, or principal amounts, the old loan is basically treated like a new loan. This may be viewed under tax laws as taxable income. This usually happens only in cases where the principal of the new loan is less than the previous loan. If the debt is forgiven, the borrower may also be responsible for taxes on the reduction.