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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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