A distressed loan is a loan that has become problematic because the borrower cannot meet the repayment terms, typically due to financial hardship. This status often arises after a loan becomes delinquent—usually missing payments for 90 days or more—and moves toward default. Distressed loans commonly include mortgages, business loans, or personal loans.
How Does a Loan Become Distressed?
A loan becomes distressed over time through missed payments:
- Delinquency: Missing one payment triggers delinquency. Lenders usually offer a grace period before applying late fees.
- Further Delinquency: Missing additional payments leads lenders to increase communication to collect the owed amount.
- Default: When payments are 90 days or more overdue, the loan is considered in default and classified as distressed or non-performing. At this stage, the likelihood the lender recovers the full amount on time is low.
Common causes include job loss, medical emergencies, divorce, or business downturns.
Real-Life Scenario
Consider Sarah, who owns a coffee shop financed by a $50,000 business loan. After regular payments, she loses customers due to nearby construction. Missing payments for three months pushes her loan into distress, prompting the lender to seek solutions.
Options for Managing a Distressed Loan
Lenders prefer resolving distressed loans through alternatives to foreclosure, which is costly and time-consuming. Common options include:
- Loan Modification: Adjusting loan terms such as interest rate or length to reduce payments.
- Forbearance: Temporarily pausing or reducing payments during short-term hardship.
- Short Sale: For mortgages, selling the property for less than owed to avoid foreclosure.
- Foreclosure: Legal seizure of collateral as a last resort.
- Sale to Investors: Lenders may sell loans at a discount to firms specializing in distressed debt.
Common Misconceptions
- Foreclosure is the lender’s preferred solution. Actually, lenders favor workouts like modification or forbearance to minimize losses.
- Distressed loans wreck credit permanently. While defaults hurt credit scores, options like loan modification can aid recovery.
- Debt forgiveness is always taxable. Some forgiven debts may be taxable income unless protected by insolvency or bankruptcy rules (IRS Topic No. 431).
Advice for Borrowers Facing Distress
If you anticipate trouble paying a loan, act early:
- Communicate promptly with your lender.
- Be honest about your financial situation.
- Understand terms like loan modification and forbearance.
- Consult nonprofit credit or housing counselors for assistance.
For more detailed guidance, see related articles on Loan Modification, Forbearance, Foreclosure, and Short Sale.
Sources:
- Investopedia, “Distressed Debt” (https://www.investopedia.com/terms/d/distresseddebt.asp)
- Consumer Financial Protection Bureau, “What is mortgage forbearance?” (https://www.consumerfinance.gov/ask-cfpb/what-is-forbearance-en-289/)
- IRS Topic No. 431, “Canceled Debt – Is It Taxable or Not?” (https://www.irs.gov/taxtopics/tc431)