Debt Restructuring: What It Is and How It Works

If you’re drowning in a sea of debt, you’ve probably wondered how you can get your head back above water. One possible solution is debt restructuring, which occurs when a creditor changes the terms of your loan agreement so that you can better manage the payments. This may include a longer loan term, a lower interest rate or even a reduction in the amount owed.

There are a few different forms of debt restructuring, so let’s take a look at how it works and whether it could help you tackle your own debt.

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What is debt restructuring?

Debt restructuring is the process of reworking an existing debt agreement to better fit your current financial situation.

If you’re struggling to make ends meet, you may find yourself picking and choosing which bills to pay first. Maybe your car loan gets paid late so you can cover groceries this week, or your credit card payment falls by the wayside because rent is due. Missing a payment can hurt your credit and result in penalty fees that’ll cost you even more money in the end.

A temporary hardship program could let you skip several payments or avoid certain fees. During a serious setback, or if you’re already months behind on bills, creditors may make an unusual offer to restructure your loan agreement. This is often called troubled debt restructuring.

Types of debt restructuring

There are a few different ways that debt can be restructured. Some of the most common include:

• Loan modification
• Payment deferral
• Extending the loan term
• Adjusting the balance due
• Waiving penalty fees that have already been added
• Reducing the interest rate

Your options for debt restructuring are likely to depend on the type of debt you have. For instance, a mortgage or auto loan might allow for an extended loan term, giving you a bit longer to repay the balance and resulting in a lower monthly payment. With a revolving account (like a credit card), adjusting the interest rate and waiving penalties could be the more logical solution.

Mortgage loan modification is a common form of debt relief that changes the terms of your home loan. If you’re experiencing temporary hardship, mortgage forbearance — or a temporary pause on mortgage payments — may make more sense.

Another type of debt modification occurs during Chapter 13 bankruptcy. Unlike other types of bankruptcy, Chapter 13 doesn’t erase debt; instead, it allows filers to keep their assets while following a restructured payment plan. The process typically lasts three to five years, after which the remainder of the court-approved debts are discharged.

Pros and cons of debt restructuring

Not sure whether debt restructuring is the right answer for you and your outstanding debt? Here are some benefits and drawbacks to consider.

Pros

  Can provide debt relief: If you’re simply unable to stay on top of your existing payment schedule, restructuring one or more accounts can help you get back on track. If your creditor is willing to reduce interest rates, waive fees, reduce balances or remove penalties, you may also end up paying less money overall.

  May help you avoid loan default: If you’re unable to make minimum payments, you risk defaulting on your debt. When this occurs, you’ll likely have your account closed and additional penalties imposed, as well as having the default recorded on your credit report. Restructuring the debt before you reach the point of default can help you save your pocketbook and your credit score.

  Doesn’t require strong credit: Unlike a personal loan or line of credit, you typically won’t need good credit to restructure your debt. This makes it a more accessible option, especially if you’ve already dinged your score with late payments or high credit utilization.

Cons

  Can damage your credit: Restructuring debt can negatively affect your credit in many ways, especially since you’re no longer paying your account as agreed. If your lender marks the debt as settled — meaning that it was paid in full, but for less than you originally owed — it can impact your score for years to come.

  May not be an option for you: Whether you can restructure your debt depends on your lender’s willingness to offer you an alternative payment option. Creditors aren’t required to offer restructuring options — so while it doesn’t hurt to ask, there’s no guarantee that debt restructuring will be available.

  Can require a lot of time and effort: Debt restructuring can be a lengthy, stressful and time-consuming process. It involves a lot of back-and-forth with creditors to find a plan that works for your current budget — and one the lender is willing to implement. Still, many borrowers who are experiencing financial difficulties find the process to be worthwhile.

How does the debt restructuring process work?

If you’ve weighed the pros and cons and believe that debt restructuring is your best course of action, here’s what you can expect:

Assess the situation

Start by examining your financial records to see where you stand. Take inventory of all your expenses, including outstanding debts and recurring monthly expenses (such as rent, utilities and even your grocery bills). Review your most recent account statements to see how much you owe, what you’re paying each month, how much interest is costing you and the status of your accounts.

Calculate how much you can afford

Before contacting lenders, it’s important to have a specific request in mind. Review your monthly budget and determine how much you can reasonably afford to put toward debt each month.

Contact your creditors

Ideally, you’d contact your lender once you realize you won’t be able to afford payments. Being proactive could be better for your credit and your odds of securing debt relief. Remember that your creditors aren’t required to agree to your request or offer any hardship options.

Weigh your options

The lender may choose to offer temporary hardship assistance or loan restructuring. If there’s a debt restructuring proposal, there may be different options to choose from, like an adjusted interest rate or repayment term.

Negotiate with the lender

You may be able to negotiate the terms of your new contract before accepting a debt restructuring offer. For example, you might try to negotiate a lower payment amount or get fees and accrued interest waived.

Accept the new terms

If you agree with the new terms for your loan, you’ll need to formally accept and sign the agreement. You’ll then be obliged to follow through with the new agreement and continue paying down your debt.

Alternatives to debt restructuring

If you aren’t sure whether debt restructuring is the right answer, you might want to consider a few debt restructuring alternatives:

• Debt consolidation: Rather than settling your debt or restructuring your accounts, consider whether a debt consolidation loan would help your financial situation. With debt consolidation, you’ll take out a new loan or line of credit to pay off your current debts. In doing so, you’re replacing your old debt with a new debt, ideally with different terms (a lower interest rate, for example).
• Refinancing: Refinancing a personal loan involves taking out a new, replacement loan in place of an existing debt. If your credit score has improved or interest rates have dropped since you took out the original loan, refinancing may make sense.
• Debt management plan: Rather than trying to negotiate a debt restructuring agreement with your lender directly, you could work with a nonprofit credit counseling organization. The counselor can negotiate with your creditors on your behalf and may be able to arrange a debt management plan. Generally, these are available for unsecured debts, like credit cards. In addition, the counselor may be able to negotiate lower interest rates, lower payments, waived fees and bring your past-due accounts current.
• Loan forbearance or deferment: Loan forbearance or deferment allows you to temporarily skip several payments without paying late fees or having your account be reported late to the credit bureaus. These could be good options if you experience a temporary setback, but don’t need or want to permanently change your loan. Student loan forbearance is common, though mortgage lenders and credit card issuers frequently offer them as well.
• Chapter 7 bankruptcy: If you’ve tried everything and still can’t stay on top of your debt, bankruptcy might be your last resort. With Chapter 7 bankruptcy, some assets may be sold to satisfy creditors and qualifying debt is discharged (or written off). Keep in mind that bankruptcy will have a sizable negative effect on your credit score — still, for some borrowers, filing for bankruptcy is the best option for a fresh start.