Though loan restructuring and refinancing may sound similar, they are two different processes that are often mistaken as the same. In this article, we explain the similarities and differences between these two processes, so you can take the right decision for your loans.
First, let’s take a look at what happens in loan restructuring and refinancing.
What is loan restructuring?
Broadly speaking, restructuring is the process of altering an ongoing loan to change the existing terms of a contract. Generally, borrowers opt for loan restructuring when they face a risk of default and find it extremely challenging to pay their loans on time.
In simple terms, restructuring can be described as the process of:
- Increasing the loan repayment tenure
- Altering the frequencies of interest payments
- Or reducing the loan EMI
so as to make it easier for the borrower to repay the loan on time. Restructuring usually occurs in extreme conditions when borrowers are at the brink of bankruptcy or are deemed financially unstable and are unable to meet the further loan obligations.
Loan restructuring is a more desperate option taken when borrowers are at the verge of defaulting. It is chosen when negotiating the alteration of an existing loan contract is the only way to avoid loan defaults.
Can loan restructuring affect credit scores?
Yes, restructuring negatively impacts your credit score. Which is why, it’s highly recommended that restructuring should be the last option, when no other options are available.
However, One-time Loan Restructuring doesn't affect Credit Scores
The RBI announced a first of its kind, one-time restructuring benefit for both personal and corporate loans due to the Covid-19 pandemic. This measure is intended to offer financial relief to the millions of Indians impacted financially due to the Coronavirus pandemic.
It's a great relief to borrowers as well as lenders since the restructuring process would happen without classifying these accounts as non-performing assets. However, note that this benefit is available only until the end of 2020 and must be implemented within 90 days of invocation.
What happens in loan restructuring?
In loan restructuring, the lender and borrower negotiate the terms of an existing loan contract and both parties come to an agreement. It is advisable to update your lender if you cannot repay your loans on time, or if a layoff has compromised your financial stability. Giving a heads up to your lender may help you as they may be sympathetic to your financial situations and provide you with some relaxation.
No lender would want their borrowers to default on their loans. Lenders believe that recovering the cost of the loan is better than the borrower filing bankruptcy, in which case, the lender does not recover the loan amount. As a result, most creditors agree to negotiate with underwater borrowers to restructure the terms of the loan such as extending the payment period or waiving late fees or changing the frequency of interest payments.
Banks are willing to restructure loans if
- It allows them to recover their debts
- Banks have confidence in the intent and capability of the borrower
What is loan refinancing?
Loan refinancing means applying for a new loan or loan instrument that has better terms than the previous one and can be used to pay the previous loan obligations. Generally, borrowers opt for loan refinancing when they come across better loan terms elsewhere.
An example of loan refinancing would be applying for a new, comparatively cheaper loan and using the proceeds from that loan to pay off the balance from an existing loan. Refinancing is a more quicker process than restructuring because in refinancing it is easier to qualify for and it has a positive impact on the credit scores since the payment history will portray the original loan as paid off.
Is refinancing a good idea?
Refinancing can be done for various reasons such as reducing interest rates on loans, consolidating loans, changing the loan structure or to reduce the overall loan burden. Borrowers with good credit scores can greatly benefit from refinancing as they are highly capable of securing more favourable contract terms and lower interest rates.
Refinancing can be done for the following reasons:
- To have better monetary benefit in terms of interest rates
- To have a longer tenure for repayment
- To borrow additional amount
- To enjoy better service and features at the new lender
- To reduce the cost of the loan
Additional Reading: What is home refinancing?
Example for how loan refinancing and loan restructuring work:
Mr X takes a loan of Rs. 1 crore for his business at an annual interest rate of 4% p.a. for a term of 6 years. However, assume that 2 years later Mr X's business is suffering a downturn. He is unable to service the loan and interest payments. The lender sends frequent notices to Mr X asking him to pay the delayed loan EMIs along with the penalties.
Now the bank and Mr X reach a deal in which the bank allows him 6 more years to repay the loan. This is an example of restructuring.
However, one year later he realises that he can take a similar loan at just 3% now because the market conditions have changed and his credibility has improved because of a stronger balance sheet. He takes this new loan at a lower rate to replace the other loan. This is refinancing.
Snapshot of the Differences between Loan Restructuring and Loan Refinancing
Restructuring is the process of altering an ongoing loan to change the existing terms of a contract.
Loan refinancing is the process of shifting an ongoing loan from one lender to another.
The major objective of restructuring is to avoid loan defaults.
The major objective of loan refinancing is to make use of better interest rates and loan terms.
When an individual opts for restructuring then the credit report portrays ‘restructured’.
There is no effect on the credit report when an individual opts for refinancing.
Loan restructuring can affect your credit scores negatively. It’s difficult to bounce back from a restructured loan.
Loan refinancing may affect your credit score temporarily, since you’re applying for a new loan. However, the temporary drop bounces back, once you start repaying the loan with the new lender.
Though debt restructuring and refinancing may sound the same, both are different processes and can have different objectives. Make sure to understand the differences between both, so that you can choose the right one, as per your financial needs.