Loan Modification

A loan modification is a permanent change to one or more terms of an existing loan, agreed between the lender and the borrower, without replacing the loan with a new one. The interest rate, the repayment period, the payment amounts or the principal itself may be altered. Modifications are most often made when a borrower can no longer meet the original terms and the lender judges that revised terms will recover more than enforcement would.

Modifications are also made for commercial reasons unrelated to distress, such as repricing a loan to keep a good customer or changing the reference rate. The distressed kind overlaps with forbearance, a term that also covers temporary relief, and with loan restructuring, which usually denotes a wider renegotiation. It differs from refinancing, in which a new loan repays the old one.

• Interest rate reduction. The rate is lowered, for a period or for the remaining term, or a variable rate is converted to a fixed one.
• Term extension. The maturity is lengthened so that each payment is smaller.
• Capitalisation of arrears. Missed payments are added to the principal and repaid over the remaining term.
• Principal forbearance. Part of the principal is set aside, bearing no interest, and falls due at maturity or on sale of the property.
• Principal forgiveness. Part of the debt is written off. Lenders rarely agree to this.
• Payment restructuring. The loan is switched to interest-only for a time, or the payment dates are changed.

Several measures are often combined to reach a payment the borrower can sustain.

For consumer and mortgage loans, the process is run by the servicer as part of loan servicing. A borrower in or near delinquency applies and provides evidence of income, expenses and the cause of hardship. The servicer assesses whether the borrower qualifies and what payment is affordable, and compares the expected recovery from modifying with the expected recovery from foreclosure or other enforcement, commonly by a net present value test. Mortgage programmes often require a trial period of several payments at the new amount before the modification becomes permanent. The agreed changes are documented in a modification agreement and entered in the servicing system.

Where a loan has been sold or securitised, the servicer must act within limits set by the investors or by the servicing agreement, a constraint described under loan modification provision. For corporate loans, modification takes the form of an amendment agreement negotiated with the lender or, in a syndicated loan, approved by the required majority of lenders, and may accompany a covenant waiver.

Large-scale modification programmes have been used in crises. In the United States, the Home Affordable Modification Program ran from 2009 to 2016 and paid incentives to servicers and investors to reduce mortgage payments to an affordable share of income. During the pandemic of 2020, lenders in many countries granted payment deferrals to large numbers of borrowers, and regulators clarified that such general measures need not automatically be classed as distressed. Consumer protection rules in several countries now require lenders to consider alternatives before enforcing against a home.

Under IFRS 9, a lender assesses whether the changed cash flows are substantially different from the original ones. If they are, the old loan is derecognised and a new one recognised at fair value. If not, the gross carrying amount is recalculated as the present value of the revised cash flows discounted at the original effective interest rate, and the difference is recognised as a modification gain or loss. A modification granted because of financial difficulty is also evidence relevant to moving the loan to a later impairment stage, as explained under significant increase in credit risk.

Under US accounting rules, concessions to borrowers in financial difficulty were for decades reported as troubled debt restructurings. That designation was removed for lenders that have adopted the current expected credit loss standard, under an update effective from 2023, and replaced by disclosures about modifications made to borrowers in difficulty.

Bank supervisors want to prevent modification from being used to hide bad loans. In the European Union, a modified exposure is classed as forborne when a concession is granted to a debtor facing financial difficulty. A forborne loan may be performing or non-performing; one that is non-performing must show a period of regular payment, at least a year, before it can return to performing status, and it then remains under probation for a further period. These rules are tied to the reporting of the non-performing exposure and to provisioning. Similar definitions were issued by the Basel Committee in guidance on problem assets.

Successful modifications avoid the costs of enforcement and allow borrowers to keep their homes or businesses. Many, however, fail: a share of modified loans default again, particularly where the payment was not reduced enough or the borrower's difficulty was permanent. Critics of crisis-era programmes pointed to slow processing, lost paperwork and conflicts of interest for servicers. From the investor's side, repeated extensions without realistic prospects of repayment postpone the recognition of losses. A modification may also be recorded on the borrower's credit file and can have tax consequences where debt is forgiven.