Barbara Sadler: Discounted Payoff

A discounted payoff (DPO) is the repayment of an obligation for less than the principal balance. Discounted payoffs often occur in distressed loan scenarios but they can also be included as contract clauses in other types of business dealings.

Understanding a Discounted Payoff

Discounted payoff is a business term that may arise in several different scenarios. Most commonly it can be part of a negotiation to pay off a lender for an amount below the total balance due. It can also be used in some business dealings as an incentive to pay off an obligation early.

Distressed Debt

A Discounted Payoff can be one alternative for resolving issues involving delinquent debt. In the case of delinquent debt, the lender will usually agree to a discounted payoff after all other options have been exhausted. In some cases a discounted payoff may also be part of a bankruptcy court settlement in which an order is delivered for a pay off amount below the obligation as part of a final agreement. In most cases of distressed debt discounted payoff, the lender takes a loss for the value of the contracted debt and interest that the borrower is no longer obligated to pay.

Collateral backed loans that end in a discounted payoff offer a special case for settlement since they have collateral which reduces the risks for the lender. With an asset-backed loan discounted payoff the lender can agree to a discounted payoff level while also exercising the right to seize the underlying asset. In some instances the lender may be able to break even or take less of a loss because of the difference in equity value vs. payoff value of the asset being levied.

In some business dealings, including loan agreements, a lender may include a contract clause that offers a borrower a discounted payoff with no repercussions. In these instances the discounted payoff serves as an incentive for the borrower to pay off their obligations sooner. Some of the benefits to the lender are more upfront cash received and lower default risks since payments are made and obligations are met in a shorter time frame. Some accounts payable contracts may also fall under the discounted payoff category. For instance, a seller may include terms like 10 net 30 which give the buyer a 10% discount for paying their bill within 30 days.

Discounted Payoff Example

Each discounted payoff will have its own circumstances and terms. Discounted payoff can be beneficial when they offer a borrower or buyer an advantage. Oftentimes though they are negotiated to stop negative credit history or reach a final debt settlement. Once a distressed Discounted Payoff has been negotiated between a borrower and lender, the borrower usually has to raise the capital to pay off the loan in a lump sum payment by a specified date in the near future. One example of a situation where a discounted payoff can be especially useful in utilizing is in the involvement of a third-party bridge lender. A bridge loan involves a third party who provides the cash to the borrower to pay off the discounted payoff while also extending additional capital with new terms. This scenario can be helpful when maintaining collateral is important but it still leaves the borrower with an outstanding balance, often at a higher interest rate than previously held. The discounted payoff amount will usually form the new liability for the property. Bridge lenders may also require the borrower to pump in a substantial amount of equity into the asset, in order to have a sufficient margin of safety on the bridge loan.

Types of Default and the Consequences

Default is the failure to repay a debt including interest or principal on a loan or security. Default can have consequences for borrowers.

How Does Loan Modification Work?

A loan modification is a change made to the terms of an existing loan because the borrower is unable to meet the payments under the original terms.

Payoff Statement

A payoff statement is a statement prepared by a lender providing a payoff quote for prepayment on a mortgage or other loan.

Set-Off Clause Definition

A set-off clause is a legal clause that gives a lender the authority to seize a debtor’s deposits when they default on a loan.

Take-Out Commitment Definition

Take-out commitment is a written guaranty by a lender to provide permanent financing to replace a short term loan at a specified future date.

Non-Performing Asset (NPA) Definition

A non-performing asset refers to loans or advances that are in jeopardy of default.

Distressed Commercial Real Estate – Discounted Loan Payoffs

While the majority of commercial real estate loans scheduled to mature in the coming years are healthy and should have little trouble refinancing when they mature, distressed debt continues to present unique loan strategies and restructurings, including discounted loan payoffs. Some of these distressed loans were extended during the financial crisis of 2007/2008, offering modest pay downs and deferring their ultimate repayment.

A discounted loan payoff (DPO) is the repayment of a loan for less than the outstanding balance. DPOs are typically reserved for distressed assets that have declined significantly in value. The write-off of any portion of the loan principal is an expensive proposition to the lender. Prior to accepting any such loss, the lender determines that the borrower is unable to infuse additional equity and the prospect of foreclosing upon and selling the asset will not recover the principal. The payoff amount with the lender should approximate the value that the lender expects to recover from the asset through the foreclosure process. DPOs allow the bank in clearing troubled debt and create capital for future lending. DPOs can be financed with new debt or additional equity. A key consideration for any investor in a distressed debt transaction is identifying the cause of the distress. Pricing of distressed debt is driven primarily by loan resolution or exit strategies, loan terms, underlying cash flow and value, guarantees, capital needs and related risk and return factors. These variables are subject to due diligence. Targeted rates of return reflect the risk in the underlying property, market and loan resolution strategy. The underwriting of troubled debt typically involves cash flows for the loan resolution strategy. There are two general types of investors, namely yield or return investors and ownership driven investors. Investors who navigate these factors are presented with the opportunity to acquire interests in commercial properties at a discount. Borrowers are able to utilize any equity infusions to perform critical tenant improvements to retain and attract new tenants, thereby starting down the road of increasing the property’s value. The distressed commercial real estate market is complex. Many of these loans are intricately structured. There are also more stringent bank loan underwriting criteria and rising interest rate uncertainties. Due to these complexities, investors should consult with advisors and financiers who are experienced in distressed debt resolutions. Loan restructurings may have significant tax consequences to both the lender and the borrower. Generally, the cancellation of indebtedness by the lender results in taxable ordinary income to the borrower and the lender would reflect a corresponding loss. Investors should consult their partner to discuss these tax and other implications.

Default is the failure to repay a debt including interest or principal on a loan or security. A default can occur when a borrower is unable to make timely payments, misses payments, or avoids or stops making payments. Individuals, businesses, and even countries can fall prey to default if they cannot keep up their debt obligations. Default risks are often calculated well in advance by creditors. A default can occur on secured debt such as a mortgage loan secured by a house or a business loan secured by a company’s assets. If an individual borrower fails to make timely mortgage payments, the loan could go into default. Similarly, if a business issues bonds essentially borrowing from investors and it’s unable to make coupon payments to its bondholders, the business is in default on its bonds. A default has adverse effects on the borrower’s credit and ability to borrow in the future.

Default on Secured Debt

When an individual, a business, or a nation defaults on a debt obligation, the lender or investor has some recourse to reclaim the funds due to them. However, this recourse varies based on the type of security involved. For example, if a borrower defaults on a mortgage, the bank can reclaim the home securing the mortgage. Also, if a borrower defaults on an auto loan, the lender can repossess the automobile. These are examples of secured loans. In a secured loan, the lender has a legal claim on the asset to satisfy the loan. Corporations that are in default or close to default usually file for bankruptcy protection to avoid an all-out default on their debt obligations. However, if a business goes into bankruptcy, it effectively defaults on all of its loans and bonds since the original amounts of the debt are seldom paid back in full. Creditors with loans secured by the company’s assets, such as buildings, inventory, or vehicles, may reclaim those assets in lieu of repayment. If there are any funds left over, the company’s bondholders receive a stake in them, and shareholders are next in line. During corporate bankruptcies, sometimes a settlement can be reached between borrowers and lenders whereby only a portion of the debt is repaid.

Defaulting on Unsecured Debt

A default can also occur on unsecured debt such as medical bills and credit card debts. With unsecured debt, no assets are securing the debt, but the lender still has legal recourse in the event of default. Credit card companies often give a few months before an account goes into default. However, if after six months or more, there have been no payments, the account would get charged off meaning the lender would take a loss on the account. The bank would likely sell the charged-off account to a collection agency and the borrower would need to repay the agency. If no payments are made to the collection agency, a legal action might be taken in the form of a lien or judgment placed on the borrower’s assets. A judgment lien is a court ruling that gives creditors the right to take possession of borrowers’ property if they fail to fulfil their contractual obligations.

Alternatives to Default

A good first step is to contact your lender as soon as you realize that you may have trouble keeping up your payments. The lender may be able to work with you on a more attainable repayment plan or steer you toward one of the federal programs. It is important to remember that none of the programs are available to people whose student loans have gone into default. You may be sure the banks and the government are as anxious to get the money as you are about repaying it. Just make sure you alert them as soon as you see potential trouble ahead. Ignoring the problem will only make it worse.

Defaulting on a Futures Contract

Defaulting on a futures contract occurs when one party does not fulfil the obligations set forth by the agreement. Defaulting here usually involves the failure to settle the contract by the required date. A futures contract is a legal agreement for a transaction on a particular commodity or asset. One side of the contract agrees to buy at a specific date and price while the other party agrees to sell at the contract specified milestones.

Sovereign Default

Sovereign default or national default occurs when a country cannot repay its debts. Government bonds are issued by governments to raise money to finance projects or day-to-day operations. Government bonds are typically considered low-risk investments since the government backs them. However, the debt issued by a government is only as safe as the government’s finances and ability to back it. If a country defaults on its sovereign debt or bonds, the ramifications can be severe and lead to a collapse of the country’s financial markets. The economy might go into recession, or its currency might devalue. For countries, a default could mean not being able to raise funds needed for basic needs such as the food, police, or the military. Sovereign default, like other types of default, can occur for a variety of reasons.

Consequences of Default

When a borrower defaults on a loan, the consequences can include:
• Negative remarks on a borrower’s credit report and lowering of the credit score, which is a numerical value or measure of a borrower’s creditworthiness
• Reduced chances of obtaining credit in the future
• Higher interest rates on existing debt as well as any new debt
• Garnishment of wages and other penalties. Garnishment refers to a legal process that instructs a third party to deduct payments directly from a borrower’s wage or bank account.
When bond issuers default on bonds or exhibit other signs of poor credit management, rating agencies lower their credit ratings. Bond credit-rating agencies measure the creditworthiness of corporate and government bonds to provide investors with an overview of the risks involved in investing in bonds.

Loan Modification

Loan modification is a change made to the terms of an existing loan by a lender. It may involve a reduction in the interest rate, an extension of the length of time for repayment, a different type of loan, or any combination of the three. Such changes usually are made because the borrower is unable to repay the original loan. Most successful loan modification processes are negotiated with the help of an attorney or a settlement company. Some borrowers are eligible for government assistance in loan modification.

How Loan Modification Works

Although a loan modification may be made for any type of loan, they are most common with secured loans such as mortgages. A lender may agree to a loan modification during a settlement procedure or in the case of a potential foreclosure. In such situations, the lender has concluded that a loan modification will be less costly to the business than a foreclosure or a charge-off of the debt. A loan modification agreement is not the same as a forbearance agreement. A forbearance agreement provides short-term relief for a borrower with a temporary financial problem. A loan modification agreement is a long-term solution. A loan modification may involve a reduced interest rate, a longer period to repay, a different type of loan, or any combination of these.

There are two sources of professional assistance in negotiating a loan modification:
• Settlement companies are for-profit entities that work on behalf of borrowers to reduce or alleviate debt by settling with their creditors.
• Mortgage modification lawyers specialize in negotiating for the owners of mortgages that are in default and threatened with foreclosure.

Payoff Statement

A payoff statement is a statement prepared by a lender providing a payoff quote for prepayment on a mortgage or other loan. A payoff statement or a mortgage payoff letter will typically show the balance a borrower must pay to close their loan. It may also include additional details such as the amount of interest that will be rebated due to prepayment by the borrower. Payoff statements provide clear disclosure for a borrower on the total amount they must payoff to close a loan account. They can also include other important loan details such as the remaining payment schedule, rate of interest and money saved for paying early. A borrower can request a payoff statement on any type of loan.

How a Payoff Statement Works

Requesting a payoff statement is commonly the first step in paying off a loan. Different types of lenders will have varying formats for payoff statements. Online lenders will generally provide borrowers with a payoff quote that details the exact amount a borrower will need to pay on a specific day to repay the loan early. In loans issued by traditional financial institutions, a borrower may need to contact a customer service representative directly rather than obtaining a payoff quote online. What is a payoff quote? It is the amount of money left to pay off a loan.
Traditional financial institutions will usually create a more formal payoff statement that comprehensively details payoff information regarding the loan. Generally, payoff statements will base their prepayment quote on the next forward payment date. Some lenders may have certain penalties or fees associated with a payoff so borrowers should check their loan agreements prior to requesting a payoff statement to understand the terms. Payoff statements can be used in collection actions for all types of loans. If a borrower is negotiating a consolidation loan with a new lender they can request payoff statements from the creditors which they seek the proceeds of their new loan to go towards. In a consolidation loan deal, a financial institution may choose to pay off each loan with proceeds of the consolation loan according to the information provided in the payoff statements. A borrower may also be presented with a payoff statement from a creditor if collection action has been taken on a specific debtor account. Generally, payoff statements will be associated with serious collection action usually involving a lien.