What is a Loan Deferral and Do I Need One?
Payment holiday, moratorium, forbearance, loan deferral – I am sure you have been hearing all these terms in light of the Covid-19 pandemic and may not have a clue what they are. What do they mean and how could they affect you?
If you currently have a mortgage, car loan, business loan, student loan, unsecured loan or any other type of loan, then you may be able to seek some type of reprieve from making payments if your income has been cut or curtailed. How will taking advantage of one of these programmes affect you in the long run? Before I answer that I want you to first understand what affects your loan payments.
There are four (4) things that generally affect how much your loan payment is:
- Principal (how much you borrow)
- Interest (what rate is your lender charging to lend you the money)
- Tenure (how long will you have to repay the loan)
- Frequency of payment (monthly, quarterly, annually etc.)
What would cause your loan payment to go down?
- Decrease in Principal – borrow less and you pay less
- Decrease in interest Rate – lower financing cost means you pay less
- Increase in Repayment Years – The longer the repayment period the less you pay monthly (but the more you pay in interest over time)
- Increase in payment frequency – The more frequently you pay, the lower that payment will be e.g. paying 12,000 monthly vs paying 150,000 one time a year.
Because of Corona a lot of persons have either heard about or are thinking about some sort of reprieve from their loan payments. Financial Institutions have jumped to the cause and have responded with relief packages to aid their customers. The Private Sector of Jamaica (PSOJ) has done a great job of collating the responses of the main financial institutions to the Covid-19 crisis currently being faced. That list can be accessed here: https://psoj.org/wp-content/uploads/simple-file-list/Financial-Institution-COVID-19-Relief-Packages-v10.pdf
The banks may use the terms interchangeably or the terms may have different meanings at different institutions so if you are seeking to change your agreement with the bank, ensure you know which one you in fact are signing up for.
So the terms mentioned before- payment holiday, deferral, forbearance or moratorium generally mean that an agreement is made with the customer that they are not required to make payment for a specified time period. This may also mean that you are required to make interest only payments during the time or some other agreed reduce payment. Each situation would be different and it will require some discussion with your lender to find the solution that best suits your circumstance. I want you to be as prepared for that discussion as possible and to understand what the consequences of each are.
In general, local banks are offering 3 month, 6 months and 12 months deferrals and moratoriums. Reduced interest rates, waiver of transaction fees, increase in credit limits or extension of loan tenure. So two out of the four things that would reduce your payments are being offered. (The banks can’t reduce the principal and most loans are already paid monthly).
What does applying for a loan deferral, or extending your loan repayment period, or asking for other modifications to your loan terms mean financially? I’m going to demonstrate with a few scenarios what the impact of a loan deferral means and questions you should clarify before taking any of these options.
For most loans, interest will still be accruing if you take a loan deferral. Rarely would a lender defer all payments of BOTH principal and interest. If they do, then your loan is just extended by the length of the deferral time. It is important for you to ask if interest will still be accruing in the deferral period. Why? Let’s see some calculations:
Scenario 1: Interest is accruing and added to your principal balance each month
While interest is accruing, it means even though you are not making a payment, interest is still being charged on your outstanding principal balance. E.g. suppose you borrowed $20 Million for 30 years and by year 5 you had a balance of $19 Million. You then decided to defer the loan for one year. Interest will continue to be charged monthly on the $19M and by the end of the deferral year, the principal outstanding would actually be $20.4 M. You would end up owing more than you initially borrowed.
How far you are in the loan would impact that calculation dramatically. If you were in year 25, you would owe about $7 M. If you deferred that loan for 1 year, at the end of the year with interest still accruing, you would owe $7.5 M. The reason why is a function of the interest being charged on a lower balance.
The table below summarizes that if you very far into a loan repayment and interest is accruing, then deferring a loan is not as bad as if you just started repaying the loan. In this example, in year 5 deferring for a year means paying $12 M more in interest. In year 25, deferring for a year means paying $839,057 in interest. That’s the cost of a loan deferral if interest is still accruing.
Scenario 2: Borrower continues to pay Interest only each month
Let’s look at what would happen if we continued paying interest only during the deferral period. If you are early into the loan, that interest calculation would be much larger (because your interest is a percent of what you still owe). For our example of a $20M, 30-year loan at 7.5%, in year 5 your interest payments would be $124k (in comparison to the payment before of $139k, which is not much of a big difference), but in year 25, the payment would only be $43k.
The cost of paying interest only in year 5 would be $1.49 Million while the cost of paying interest only in year 25 would be $523k as seen in the table below. This would be the better option if you could choose between the two scenarios.
Scenario 3: Interest is Accumulated and paid as a one-time payment at the end of the loan as a balloon payment.
In this scenario, the interest that you had not paid during the deferral period would accumulate and at the end of the loan, you would pay it in full as a balloon payment. The loan would be extended by the deferral period of 12 years.
Summary of Deferral Options
I used the 12-month example with a 30-year loan to show you the general impact, but the calculation would be similar for any loan period of any amount. The longer you defer for, the earlier you are in your repayment schedule or the higher your interest rate is, the more interest you would have to pay if you chose to defer a loan. The disadvantage to a deferral is that there is always a cost especially you are not making any payments at all. The cost could be an extended repayment time or additional interest expense.
Loan deferrals can however assist you in the following ways:
- You would have smaller or more manageable payments that can help you weather the storm
- Your Credit Bureau score would not be as severely impacted (you would not be reported as late or delinquent)
Other Loan Refinancing Options
Reducing Interest on the Loan
If your bank says they are lowering your interest rate, all else remaining the same, this would simply mean that the new rate you are being charged would make your payment lower. E.g. Moving from 6% to 5% would mean a payment going from $133k a month to $119k for a 30 year, $20M loan.
See my calculator here to figure out what a reduction in interest rate translates to.
Increasing the Loan Term
This would reduce the monthly payment because the payments are being spread over a longer period of time. E.g. Moving from 25 to 30 years would mean a payment going from $129k a month to $119k for a 6%, $20M loan. The consequence of this is that you will pay a lot more interest over time. In this same example, you would pay $4.5 MILLION more in interest by extending the loan by 5 years.
See my calculator here to figure out what increasing the loan period translates to.
Also, If you pay your loan principal down faster, then you will pay off your mortgage much earlier if it is a reducing balance loan. If you do have to do a deferral and you have extra cash coming in afterwards, pay back more to the principal so that you are not affected in the long run.