How Do Debt Restructuring and Debt Refinancing Differ?

Debt restructuring and debt refinancing are often used interchangeably, even by experienced financial professionals, but they are two separate processes. While both relate to debt reorganization occurring to improve a person or an entity’s financial condition, the two differ regarding the contract, as well as circumstances, reasons, and frequency of use.

When it comes to contracts, debt restructuring involves the modification of an already existing contract. For example, common restructuring would be prolonging the due date for the principal payment on a debt contract or altering the frequency of interest payments. Meanwhile, debt refinancing is about starting a new contract with better terms than the previous one and can pay down the latter’s obligation. For example, a borrower can apply for a new, cheaper loan and use its proceeds to pay off the liabilities of an existing loan.

As for circumstances, reasons, and frequency of use, debt restructuring usually happens in special circumstances and is more extreme than debt refinancing. Restructuring could negatively impact a person or company’s credit score, so it is often the last resort for borrowers in dire situations. These include borrowers considered financially unstable and unable to meet debt obligations. They are running the risk of defaulting and thus must negotiate with their creditors to modify the existing contract. The modifications, however, should serve both parties.

If borrowers are aware that they will not pay on time or that a layoff has destabilized them financially, it is advisable to negotiate with the lenders. Lenders do not want borrowers to default on their loans because bankruptcy-related costs are much higher. Thus, in most cases, they are willing to negotiate with distressed borrowers to restructure the loan. Possible restructuring means include waiving late fees, extending payment days, or changing the frequency of payments.

Another option used by large, well-established corporations is swapping out debt for equity. Furthermore, such swaps can also happen with mortgages when a household trades equity in their home to lower the mortgage payments. Debt restructuring enables borrowers to preserve their liquidity, which allows them to restore or maintain cash flow sources to repay the renegotiated loan.

Debt refinancing is quicker and easier to execute, and thus, more liberally used than restructuring. Furthermore, it impacts a credit score positively because the original loan will be marked as paid off.

While the reasons why borrowers may opt for refinancing vary, among the most common ones are to reduce interest rates on loans, consolidate debts, and change the loan structure. Those with high credit scores could benefit from refinancing because it can secure more favorable contract terms and lower interest rates.

Fundamentally, refinancing a debt means replacing one loan with another. Thus, this strategy is often employed when a change in interest rates that may impact new debt contracts occurs. For example, an interest rate cut by the US Federal Reserve will lower the yield on interest payments of new loans, which will benefit borrowers. In this circumstance, debt refinancing enables them to pay a much lower interest over time for the same nominal loan.

Before trying to pay off loans early, borrowers must do their due diligence and calculate and compare the net present value of the cost of the two loans. The reason is many fixed-term loans have call provisions for penalties in the case of paying down loans before their maturity.

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