When a loan is forgiven the debt obligation to the borrower has been removed, usually for part or all of the principal of the loan. There are several different reasons for doing this. Most lenders do not intend to forgive their loans, because collecting both the principal and the interest is how the lender makes a profit. But some loans are more easily forgiven than others, and sometimes forgiving a loan is in the best interest of a lender.
Definition
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A forgivable loan is designed to be forgiven if a specific series of requirements are met. These requirements vary according to the type of loan, but it is up to the borrower to fulfill them. At that time, the lender removes the burden of debt and no longer considers any money to be owed. Forgivable clauses typically are written into the contract of the loan from the beginning, although lenders may consider forgiving debt on other loans as well.
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Development Loans
A common type of forgivable loan is a development loan issued by a local government or by lenders participating in a government program. These loans are designed to help improve more destitute parts of a city or encourage the local economy. Most borrowers are contractors and small businesses. By completing a building project or reaching a certain level of success, the borrower can fulfill the necessary requirements and have the loan forgiven. Governments use these loans to encourage specific community goals.
Employee Incentives
Another type of forgivable loan is used to provide employee incentives. In some industries in which firms enter fierce competition to hire specific talent, organizations offer potential employees a signing bonus, which essentially is a large cash payment for coming to work for the company. This payment acts as a forgivable loan. If the employee works for the organization and performs as expected for the first six months or year -- whatever time frame is specified in the agreement -- the loan with be forgiven and considered income. If the employee leaves, it is considered debt and must be paid back.
Bad Debt
In some cases, lenders forgive debt on loans to take a loss. This occurs as part of debt settlement, where borrowers are no longer able to make payments on their loans and must find alternatives. One alternative is to pay a lump sum on the principal while having the lender forgive the rest of the debt. Both sides suffer, but neither experiences the alternative loss. This occurs in many short sales performed to avoid foreclosures. The debt forgiven in this case also counts as income and is often taxed.