λ exonuclease degrades one strand of duplex DNA in the 5'-to-3' direction to generate a 3' overhang required for recombination. Its ability to hydrolyze thousands of nucleotides processively is attributed to its ring structure, and most studies have focused on the processive phase. Here we have used single-molecule fluorescence resonance energy transfer (FRET) to reveal three phases of λ exonuclease reactions: the initiation, distributive and processive phases. The distributive phase comprises early reactions in which the 3' overhang is too short to stably engage with the enzyme. A mismatched base is digested one-fifth as quickly as a Watson-Crick-paired base, and multiple concatenated mismatches have a cooperatively negative effect, highlighting the crucial role of base pairing in aligning the 5' end toward the active site. The rate-limiting step during processive degradation seems to be the post-cleavage melting of the terminal base pair. We also found that an escape from a known pausing sequence requires enzyme backtracking.