Over-indebtedness often seems hopeless. But even if you're not necessarily facing default, you can still improve your credit terms under certain circumstances. As a result, it's worth considering possible alternatives to existing contracts at some point – even in the absence of liquidity issues.
It's a case-by-case decision each time whether restructuring your loan situation is financially viable. So also consult financial experts when making your decision. The debt restructuring model is also finding use at the state level.
In the following article, learn what the difference is between individual and collective debt restructuring and exactly what to look for when considering it.
What is meant by debt restructuring?
Debt restructuring – also known colloquially as loan replacement – generally refers to the replacement of one loan with another debt ratio. This can have various reasons and makes sense especially if the debtor can benefit from lower interest rates of the new contract or if he prefers only one debt together with its conditions instead of several smaller loans. For economic reasons, it must be clarified to what extent the old loans can agree a potential redemption. The new contract is then economically declared as a novation.
Legally, there is a clear distinction between debt restructuring and other financial restructuring measures. For example, a classic debt forgiveness is not a rescheduling, because the creditor does not change, but assigns part of his claims in favor of the debtor. Similarly, a so-called deferral offers only a change in the redemption ratios and no rescheduling – one or more installment payments are adjusted together. A debt rescheduling with deferral only exists if the term is extended backwards because certain repayments are suspended.
Consolidation, on the other hand, changes the status of a short-term credit agreement to a long-term relationship with the same creditor. Since these are two different relationships, they are not legally referred to as debt rescheduling. In addition, not every contract amendment and every addendum triggers a debt rescheduling; after all, the old credit agreement is only modified and not replaced. The previous creditor remains in existence, which is why he can also track whether the terms of the contract are being adhered to even with the modifications.
Only if another credit institution appears and wants to enter into a guarantee with the debtor, it is spoken of debt rescheduling. Depending on whether the debtor is a private individual, a company or an entire state, there are various circumstances to consider, which are explained below.
Debt restructuring of private individuals
With the help of debt restructuring, a person who is in danger of over-indebtedness can significantly improve his or her credit rating as well as liquidity. Because the entry into force of a new loan – this is usually granted by a different institution as the current loans – can either have generally better interest conditions than the existing contracts or be based on a variable interest rate.
First, you as the debtor must determine your remaining debt by adding up the remaining interest costs. Then contrast the principal and installment payments of the potential new loan and compare the two sums. However, do not forget to include the rescheduling fees. These costs arise from a so-called early repayment fee (VFE), which you must assign to your previous creditors or any costs for lawyers, notaries or other experts.
Always keep an eye on the notice periods of your existing credit agreements. In the case of contracts with a variable interest rate, you can seek a debt restructuring with a notice period of at least three months, while a loan with a fixed repayment rate usually entails a notice period of six months.
However, almost always a credit agreement ends after ten years of maturity. If you want to terminate the contract beforehand, the aforementioned early repayment penalty of the institution is demanded so that remaining credit claims can still be asserted. The specific case of rescheduling your construction financing requires further considerations and framework conditions.
Corporate debt rescheduling
If a company gets into a situation of lacking creditworthiness, debt restructuring can be an alternative to improve the financial situation of the company economically. In this way, the creditworthiness of the borrower can be restored, so that further loan modifications can be sought.
The program is particularly recommended if the installments and repayments (the debt service) exceed 400% of the available cash flow. The business ratio and the debt service coverage ratio are decisive here. In addition, it is determined which creditor has the largest share of debt and with just these the debt restructuring is then carried out.
The rescheduling of debts in enterprises can be preceded by an excessive borrowing of the management. However, bad investments, high losses or a lack of equity can also have a negative impact on a company's balance sheet, so that existing creditors cannot be paid any further. These are usually other companies, suppliers and producers, partners and shareholders, the tax office or banks.
Sovereign debt restructuring
Since Mexico's financial crisis in 1982, debt restructuring has also been a way for over-indebted countries to regain some of their creditworthiness and liquidity. The most recent example is Greece's default from 2007, where there has been debate in many quarters about whether debt restructuring should be perceived as a real option when a moratorium on payments is imminent. If a country is confronted with a debt of more than 60% or with a new debt of more than 3% of the gross domestic product, restructuring measures of the state are necessary.
In addition, export revenues, tax revenues, corruption and central bank balances can also have a negative impact on government liquidity. In the long run, the latter can then no longer pay the required installments to the creditors and the state budget becomes insolvent. For example, further limits apply here, such as 150% of export earnings for government debt abroad.
Various supervisory bodies such as the EU, the International Monetary Fund or the World Bank attest to the fact that a requested debt restructuring can be carried out well and that it is also likely to be successful.
Is there any criticism of the debt rescheduling model?
In some individual cases, there is uncertainty about whether debt restructuring makes financial sense or could even make the debt situation worse. The prepayment penalty plays a role that should not be underestimated – as do the general processing fees of the new loan. Moreover, in the case of companies and sovereigns, debt restructuring is only a temporary solution that can optimize the current situation but does not address the root cause of the debt problems.
If one relies only on the power of transferring the debt burden, one runs the risk of becoming insolvent again very quickly. After all, the weaknesses that led to the initial over-indebtedness remain in place.
Another important point of criticism of debt restructuring is the inclusion of fixed interest rates and certain clauses in loan agreements. The (cross-)default clause, pari-passu clause or deterioration of financial circumstances authorize the creditor to call in the outstanding bond and installment amount immediately and in full. This means that you would have to make all remaining payments in one go with the last installment of your old loan.
In addition, such a case of default can also trigger a whole wave of cancellations by the creditor, if there are still other credit relationships with the latter. This can ensure the security of third parties in the case of government and corporate loans. In general, debt restructuring can be considered a credit event, which – similar to debt forgiveness – also triggers a payment obligation on the part of the debtor.
When is a debt restructuring worthwhile?
Debt rescheduling is worthwhile if the repayment terms of the loan agreement with the new creditor, including rescheduling costs, turn out to be more favorable on balance than the residual debt of the old loan. With attention to the notice periods, the payment of an early repayment penalty can also be circumvented, which can also have a positive financial effect.
However, not only the pure interest level is decisive for the success of the debt restructuring, but also the consideration of improved repayment rates and maturities. In addition, debt restructuring can also be useful when several different loans can be combined into one overall loan. This triggers not only the payment of a complete installment, but also a better overview for debtors us creditors, from.
While debt restructuring is profitable for individuals even if they are not in a debt situation, businesses and governments often make use of debt restructuring when they see no other way out financially. If you have a current loan, it's worth comparing the current and potential terms of the contract so that, in the best case scenario, you're in a position to receive large gains on a switch. Changing from fixed rates to variable or vice versa can be extremely lucrative economically and should be taken advantage of within the constraints of the law.
In the case of corporate and government debt, debt restructuring helps, provided that the resulting liquidity can be used to alleviate the causes of the financial situation. At the same time, the current situation of the company and the state budget can change so quickly that a regular review of the debt rescheduling is definitely worthwhile. Again, the new interest rate should result in a savings that is greater than the debt restructuring costs.
In general, it can also be said that debt restructuring also seems to make sense when other reorganization measures such as consolidation, debt forgiveness, deferment or contract amendments are not feasible – whether due to a lack of goodwill on the part of creditors or because of named clauses that could tend to exacerbate the financial difficulties.
Conclusion
Whether you are looking to optimize your credit terms or government borrowing on a national level, the principle of debt restructuring is ubiquitous in economics. This should be preceded by an urgent assessment of whether the financial situation will improve with a new loan and a new creditor to the extent that the savings will result in sufficient funds. Both the notice periods and the contracts of the old credits should always be included in detail, so that the rescheduling is also crowned with success and would not end up in an even more unfortunate situation.
The individual factors are so different that it is advisable to consult independent financial experts.