As the COVID-19 pandemic sweeps the nation and disrupts almost every aspect of the economy, lenders are facing the reality that many of their borrowers cannot make payments.
The simple response is for the lender to declare a default and initiate foreclosure (non-judicial foreclosures of business purpose loans remain mostly unaffected by recent government restrictions). However, many lenders will prefer to take an alternative course of action and attempt to restructure the loan in hopes that the borrower will be able to get back on track after the worst of the crisis passes. The two most common methods of restructuring are the loan modification and the forbearance. This article will compare and contrast these two common methods of borrower accommodations to help lenders decide which option is most feasible for their business operations as they adjust to the dynamic environment created by the COVID-19 pandemic.
The main objective of a post-default loan modification is to amend the loan terms since the borrower would be forced into default if the previously existing terms remained in effect. A loan modification operates on the basis that the loan relationship will be maintained in good standing—just under modified conditions.
A forbearance agreement, on the other hand, is an assurance given by the lender to delay the initiation or continuation of foreclosure proceedings for a specified time despite the fact that the loan remains in default. The lender and the borrower may agree to halt payments altogether during this period, or they may agree on reduced payments. Still, the forbearance agreement will mandate that the borrower return to making full payments as required per the original conditions of the loan after the forbearance window expires. Or, in cases where the loan has already matured, the forbearance would require that the loan be paid off after the forbearance expires.
Choosing the right option comes down to finding the right balance of strategy and tactics from the lender’s perspective. The following is an overview of how loan modifications and forbearances impact the different components of a loan.
If a lender chooses to make a loan modification after an event of default, the default will be withdrawn after the modification is implemented. Alternatively, if the lender chooses the forbearance option, any preexisting default will remain outstanding. The lender needs to consider the fact that if there is already a standing default, choosing the forbearance option means they will not have to re-default the loan down the road. This is particularly relevant if the loan documents include a cure period for defaults. Since a modification removes the default, any future default will still be subject to the cure period, whereas a forbearance that acknowledges the continuing default would allow the lender to immediately proceed with enforcement action upon the expiration or termination of the forbearance agreement.
Similar to the default situation, even if a loan had been previously accelerated, a loan modification will withdraw the acceleration. On the other hand, a forbearance will typically result in a loan remaining accelerated. Acceleration allows the lender to immediately collect the entire debt—which can become a point of contention if the borrower files for bankruptcy. In the majority of states, a bankruptcy court will require lenders to obtain relief via an automatic stay to accelerate the loan following the debtor’s bankruptcy filing.
A loan modification may alter the maturity date of a loan, as a loan modification can amend any provision of the original loan contract. In a forbearance agreement there would be no formal change to the maturity date because the loan stays in default status during the forbearance period. Rather than changing the maturity date, a forbearance would set a new date on which the lender can begin or continue foreclosure. The absence of a new maturity date in a forbearance offers the lender a faster reaction time in terms of enforcement action. However, modification of the maturity date may assist the borrower in refinancing the loan as the borrower will not have to explain to potential lenders why the loan is in default.
If a loan is being serviced by a third party, the lender should consider the policies and procedures of the servicer as well. Loan modifications formally amend the original loan. As a result, the servicer will generally be able to seamlessly integrate the modification terms into its servicing protocol. On the other hand, a forbearance is a more informal agreement which may include non-standard concepts such as partial payments, conditional interest forgiveness, and month-to-month changes in the payment structure. Servicers may have trouble incorporating the terms of a forbearance agreement into their systems. A lender should check with its servicer before entering into a forbearance to ensure that the terms of the forbearance will be properly implemented on the servicing side.
Both a modification and a forbearance can be flexible in resolving any miscellaneous issues that may have arisen over the course of the loan. For instance, both types of documents, when properly drafted, should include a provision which releases the lender from liability for anything that has happened up to the time of the agreement. Any specific items that a lender wants to address in an agreement with the borrower can typically be added to either type of agreement, but the lender should consult his or her attorney to make sure that is the case.
For more information about drafting forbearance agreements, see our article on Forbearance Agreements 101 here.