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Assessing the Risk of Modifying a Commercial LoanLending to a commercial borrower has the potential to be more lucrative to a creditor than lending to a consumer borrower. The average consumer borrower will take out one major loan during their lifetime – a home mortgage. A successful business may continue to take out loans as it expands its operations, creating a long-term business relationship with the lender. There are risks when lending to a commercial borrower if the business struggles. Creditors know they must evaluate the likelihood that a business will be able to repay them before entering a loan agreement. They may need to adjust their evaluation if the commercial debtor falls behind on its loan payments.

Creditor Options

When a commercial debtor misses a payment, the one thing you cannot afford to do as a creditor is to ignore it. You should respond to the first missed payment by contacting the debtor to determine the reason for the missed payment. If the missed payments continue for several months, you have a difficult decision to make. You can:

  • Use debt collection practices;
  • File a lawsuit for lack of payment;
  • Foreclose on a property related to the loan;
  • Restructure the loan agreement to make repayment manageable; or
  • Offer forbearance to give the debtor time to avoid foreclosure.

Risk Evaluation

There can be benefits for both sides when modifying your loan agreement with a commercial debtor, even if you are losing some money on the original agreement. If the business is able to rebound and repay you, they may reward your assistance by continuing to borrow from you in the future. There is also the risk that modifying the loan will not prevent the business from defaulting on the loan, costing you more than if you had sought full repayment earlier. Identifying the differences between a good and bad risk depends on the circumstances, such as:

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Differences Between Debt Consolidation and Debt RestructuringWhen a client is unable to pay a debt, it sometimes makes sense to offer to modify the loan. Though you may lose some money after the modification, it would be less of a loss than if the client filed for bankruptcy and discharged the debt. The modification may also allow you to maintain your relationship with the client. Two forms of modification are debt consolidation and debt restructuring. Though they have some similarities, they are each best suited for certain debtor situations.

Debt Consolidation

With debt consolidation, the debtor enters a new loan agreement that pays for multiple, smaller loans over a longer period of time. Debt consolidation can be attractive to the debtor because:

  • It simplifies payments of multiple loans into one payment;
  • The interest rate on the new loan can be lower than the smaller loans; and
  • The process will likely not hurt the debtor’s credit score.

From the creditor’s perspective, debt consolidation may be preferable to other loan modification options because the debtor is still expected to repay the loan in full. It is an option best suited for clients who are normally in good standing and looking for long-term savings on their debts in exchange for extending the repayment period. It may not help a client who is struggling to make basic payments.

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Requirements for Creating a Reaffirmation AgreementAfter bankruptcy filers discharge their debts, unsecured creditors may lose the ability to seek or enforce repayment. The debtor can voluntarily repay the creditor in order to keep a property but has no contractual obligation to make continued payments. In some cases, the debtor may choose to reaffirm the debt. The debtor signs a new agreement that requires him or her to repay the debt. As an incentive, the creditor may offer to refinance the debt into terms that are more manageable for the debtor. However, courts will not enforce a reaffirmation agreement unless you met the legal requirements in creating it. You could instead be liable for damages to the debtor if the court rules that the agreement violated the bankruptcy discharge injunction.

Deadline

You must meet two deadlines in order to file a reaffirmation agreement with a debtor:

  • The agreement must be filed no later than 60 days after the first meeting of creditors unless the bankruptcy court gives you an extension; and
  • The agreement must be filed before the debts are discharged as part of a bankruptcy.

The deadlines mean that you must discuss and complete the reaffirmation agreement while the bankruptcy case is ongoing. Once a debt has been discharged, you cannot create a new agreement that requires payment of the same debt from the same party. Even if the debtor agrees to reaffirm the debt, a court will likely rule that the contract is unenforceable. However, a third party who was not involved in the bankruptcy could agree to take on the debt.

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Key Differences Between Forbearance and Loan ModificationWhen a borrower is defaulting or about to default on a loan, the lender can offer to modify the loan agreement to allow the borrower to repay the debt and avoid the consequences of violating the agreement. Loan forbearance is a tool that lenders and borrowers use to temporarily reduce or stop debt payments. The borrower agrees to repay the missed payments at a later date, with interest sometimes added. Forbearance is most often used when a borrower is going through a temporary financial hardship and anticipates being able to catch up on the payments once the hardship has passed. However, forbearance is different from loan modifications, and some of the differences can be advantageous to a lender.

Separate Agreements

With a loan modification, the lender and borrower are changing the original loan agreement to create a new repayment plan that the borrower can adhere to. Loan forbearance is creating a new agreement that temporarily supersedes the original loan agreement. The forbearance agreement should state:

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Four Ways to Modify a Loan to Avoid DefaultWhen debtors are struggling to pay off loans, creditors often consider loan modification before taking more drastic legal action. Foreclosure and repossession are surer ways to recuperate money or assets from a debtor, but those methods may fail to collect the entire value of the loan. By using loan modification, the debtor still has a chance to fully repay the loan, often with added interest. Creditors are taking a risk when agreeing to a loan modification:

  • They are permanently changing the loan agreement in a way that may benefit the debtor; and
  • They are trusting that the modification will be enough to help the debtor repay the loan.

In some cases, a loan modification only delays necessary legal action to recover a debt. Creditors must judge whether the debtor is likely to repay the loan and whether the modification is worth the effort. There are several ways to modify a loan in order to assist a debtor:

  1. Forbearance: The creditor can temporarily reduce or suspend loan payments, with the agreement that the debtor will repay the difference when the forbearance period has ended. Forbearance is best used when the debtor is going through temporary financial hardship that he or she expects to recover from.
  2. Term Extension: The creditor can add years to the loan repayment schedule. The value of each payment will go down, but the overall interest paid on the loan will increase. The creditor must determine how long it is willing to delay reimbursement of the loan.
  3. Interest Rate Reduction: The creditor can temporarily or permanently reduce the interest rate on the loan, thereby lessening the payments. The money lost from the reduced interest is often added to the principal of the loan.
  4. Principal Reduction: This modification is the least favorable for creditors because it decreases the value of the loan that the debtor must repay. Creditors may forgive a portion of the debt in hopes of increasing the chance of retrieving the remaining debt. However, the creditor is accepting a loss on the loan.

Best Option

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