Distressed Borrower: What It is, How It Works

What Is a Distressed Borrower?

A distressed borrower is a borrower who is unable to fully repay their debt on time, due to financial difficulties. A distressed borrower can be either a person or a business whose income falls due to unforeseen circumstances. The situation may invoke a collection agency.

Distressed borrowers can also become distressed if they simply don't understand the terms of the loan. In the late 2000s, subprime mortgage borrowers often became distressed borrowers because they were issued loans they didn't understand and couldn't afford. Typically, lenders have the incentive to only issue loans that can be repaid, but the structure of the late 2000s mortgage market encouraged reckless lending, because mortgage originators usually didn't assume any repayment risk.

Understanding Distressed Borrowers

Distressed borrowers sometimes have different options to get current on their loans, as lenders have the incentive to find a way for borrowers to repay their debt, even if it means being repaid late or in less than the full amount owed. The most common strategies for distressed homeowners are forbearance, reinstatement, loan modifications, or a short sale.

Strategies for Distressed Borrowers

A distressed borrower can request that a lender grant them forbearance, or the suspension of payment obligations for a specific period of time. A lender typically won't agree to this option unless it is required to do so by law, because any delay in the repayment of a loan will reduce the value of that loan in the open market. The federal government, however, offers forbearance options for distressed borrowers of student loans, and some private student loan issuers are also required to offer forbearance options.

Lenders more often require that a borrower follow the reinstatement strategy, in which a borrower pays the delinquent amount in one lump sum. Depending on the terms of a loan, a lender might allow a borrower to reinstate without penalty, if their payment falls within a predetermined grace period.

Another strategy for distressed borrowers are loan modifications, which lenders will offer to either lower the total repayment amount required by the borrower or extend the length of time given to repay the full loan amount. Lenders will sometimes offer a loan modification if they are afraid that absent the modification, the borrower will default entirely on his obligations.

Distressed mortgage borrowers have the option, in some cases, of a short sale, whereby they sell their property at a loss and pay their mortgage lender less than the full amount they owe—known as a discounted payoff (DPO). Laws regulating short sales vary state by state, and in some jurisdictions, mortgage lenders are forced to accept these loss-inducing arrangements.

Example of Distressed Borrower

Twenty-five-year-old Peter bought his first home right before the financial crisis hit. His home was in a good neighborhood and in a great condition. Although the home was expensive, Peter's bank was willing to overlook his relatively low salary at a junior position in an advertising firm and offered terms that seemed favorable to him.

The financial crisis was bad news for Peter in more ways than one. The value of his property fell by roughly a quarter within two years of the crisis. Peter also lost his job at the firm. His bank savings and temporary gigs helped pay the mortgage on his home for a couple of months. Soon, however, Peter ran out of cash and became a distressed borrower.