Fundamentally, both refinancing and restructuring are debt reorganization processes taken to strengthen a person or a company’s financial outlook. Debt refinancing refers to initiating a new contract, often at better terms than a previous one, to pay off a loan. Debt restructuring is a more extreme option taken when debtors are at risk of defaulting and negotiate to alter the existing contract.

The Costs of Bankruptcy

But why refinance or restructure? A key catalyst is to avoid the cost of bankruptcy for both the borrower and the creditor. Due to the legal expenses levied on both borrower and creditor, most debt restructuring issues are settled before bankruptcy becomes inevitable. On average, attorney fees for Chapter 7 bankruptcies range anywhere between $500 and $3,500. Moreover, there are additional government paperwork filing charges, credit counseling charges and debtor education fees not to mention the severe effect on the borrower’s credit score. On the creditor’s side, if the loan was unsecured, then the creditor is out the principal as well as the agreed-upon interest payments. If the loan was secured, then the creditor has to deal with liquidating assets like real estate or automobiles. Usually, both parties want to avoid those outcomes, making restructuring and refinancing attractive alternatives.

Debt Refinancing

In debt refinancing, a borrower applies for a new loan or debt instrument that has better terms than a previous contract and can be used to pay down the previous obligation. An example of a refinancing would be applying for a new, cheaper loan and using the proceeds from that loan to pay off the liabilities from an existing loan. Refinancing is used more liberally than restructuring because it is a quicker process, easier to qualify for and impacts credit score positively since payment history will reflect the original loan being paid off.

There are various reasons for refinancing, with the most common reasons being reducing interest rates on loans, consolidating debts, changing loan structure and freeing up cash. Borrowers with high credit scores especially benefit from refinancing because they can secure more favorable contract terms and lower interest rates.

Essentially, you are replacing one loan with another, so debt refinancing is often used when there is a change in interest rates that may influence newly created debt contracts. For instance, if interest rates are slashed by the Federal Reserve, then new loans as well as bonds will offer a lower yield on interest payments, which is advantageous to borrowers. In this circumstance, a debt refinancing can allow borrowers to pay much less interest over time for the same nominal loan. It is important to note that when trying to pay down loans before maturity, many fixed-term loans have what are called call provisions—terms that impose penalties in the case of early loan repayment. In such situations, borrowers should do their due diligence in calculating the net present value of the cost of one loan versus another.

Debt Restructuring

For more dire situations, borrowers can turn to debt restructuring. At the most basic level, restructuring refers to altering an already existing contract (versus refinancing which starts with a new contract). An example of a typical restructuring would be lengthening the due date for the principal payment on a debt contract or modifying the frequencies of interest payments. Restructuring occurs mostly in special circumstances, where borrowers are deemed financially unstable and are unable to meet debt obligations. Restructuring can also negatively affect your credit score, which is why it is a last-ditch strategy.

In debt restructuring, the borrowing party must negotiate with the creditor to create a situation where both parties are better off. If you know you cannot make timely payments on your loan, or if a layoff has compromised your financial stability, then it is often prudent to begin talks with the lenders. Lenders don’t want borrowers to default on their loans because of all the aforementioned costs of bankruptcy. The majority of the time, lenders will agree to negotiate with underwater borrowers to restructure the loan, whether that means waiving late fees, extending payment dates, or changing frequencies and amount of coupon payments. Another option for large, well-established corporations is swapping out debt for equity. Debt-for-equity swaps can also occur with mortgages. In those cases, a household trades equity in their home to reduce the mortgage payments. As is often the case, the restructuring will allow borrowers to maintain greater liquidity, which can then be used to restore or maintain cash flow sources to successfully repay the renegotiated loan contract.

On another note, perhaps the most essential role for debt restructuring going forward is with sovereign bonds. Though the IMF is currently working on a framework for resolution, there is currently no international rule of law on debt restructuring, which has contributed to entities like Argentina, Greece and Puerto Rico defaulting on debt payments rather than having fair, lawful negotiations with creditors.

The Bottom Line

It is important to note that both individuals and corporations go through debt restructuring and debt refinancing, and they are fundamentally the same processes for individuals as for corporations (barring a few exceptions). Debt refinancing is used on a much broader basis in which a borrower leverages a newly obtained loan with better terms to pay off a previous loan. Debt restructuring is used when a borrower is under such financial distress that it prevents timely repayment on a loan. Understanding the similarities and differences between the two reorganization strategies is vital in both personal and corporate finance.