What is the difference between a loan modification and a forbearance agreement?
A loan modification and a forbearance agreement are two methods used to address a distressed loan. A loan modification typically involves changing the terms of the loan, such as the interest rate, payment amount, or term length. Any outstanding amounts are often placed at the end of the loan—particularly in cases of mortgage lending.
On the other hand, a forbearance agreement is a contract in which the lender agrees to temporarily not enforce its rights and remedies against the borrower in connection with a loan default. This agreement usually authorizes reduced payments for a set time—often pending the finalization of a loan modification.
A forbearance agreement will have a fixed expiration date after which the lender may exercise its rights and remedies. It may also require the borrower to achieve certain milestones within a specified time to ensure that the borrower is progressing either financially or operationally. The lender may also require additional documentation, such as modifications to any recorded documents, additional guaranties, or other collateral documents. But a forbearance agreement seldom waives any applicable existing defaults. Instead, the lender merely agrees to forbear exercising the remedies to which the lender is entitled because of the default. Even so, some forbearance agreements are useful tools to bring a loan back to performing status over an agreed period by giving a borrower time to cure its defaults.
Why are loan modifications and forbearance agreements important?
Loan modifications and forbearance agreements can be beneficial for both borrowers and lenders in several ways. For borrowers, these agreements can provide relief during financial distress, such as an inability to make timely loan payments or a default from a covenant breach. A loan modification agreement can lower the borrower’s monthly payment obligations by reducing the interest rate or extending the loan term. In some cases, the lender may offer a principal reduction or forgiveness.
A forbearance agreement, on the other hand, involves the lender not exercising its rights and remedies against the borrower in connection with a loan default. This can provide the borrower with a framework to formulate an alternative solution to default, remedy the temporary nonperformance, and schedule repayment of the debt.
For lenders, these agreements can also be advantageous. A lender may choose to temporarily forbear from exercising its enforcement rights against the borrower as an alternative to pursuing remedies. This decision can be based on whether entering into a forbearance agreement provides a greater benefit than if it were to exercise its remedies against the borrower under the loan documents. A forbearance agreement also presents the lender with the opportunity to correct errors or amend the existing loan documentation, perfect any unperfected liens on the pledged collateral, and obtain additional collateral or guarantees. Similarly, a loan modification agreement allows the lender to modify the original loan’s terms with the borrower, which can help to regain the performing status of the loan.
In the end, it’s important to consult experienced legal counsel about which option is best, to ensure the agreement reflects the lender’s goals, and to confirm that the agreement effectively releases the lender from liability concerning the debt.