Loan forbearance

What Is Loan Forbearance?

Loan forbearance is a temporary agreement between a borrower and a lender that allows the borrower to either temporarily reduce or postpone loan payments due to a period of financial hardship. This arrangement falls under the broader category of Debt Management strategies, designed to provide short-term relief without causing the loan to enter delinquency or default. While payments are paused or reduced during loan forbearance, interest typically continues to accrue on the outstanding principal balance for most loan types. The missed payments, including any accrued interest accrual, must typically be repaid later, often through a modified repayment plan or as a lump sum at the end of the loan term.

History and Origin

The concept of loan forbearance has long been a tool in financial services to manage distressed loans, particularly in times of widespread economic stress. While informal arrangements have always existed, formalized forbearance programs gained prominence during significant economic downturns. For instance, during the Savings and Loan Crisis of the 1980s, regulatory forbearance allowed many insolvent thrift institutions to remain open, even though their financial problems often worsened over time due to insufficient resources to resolve them.³¹

More recently, loan forbearance became a critical and widely implemented measure during the COVID-19 pandemic. In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was enacted, providing significant protections and rights for borrowers with federally-backed mortgages and federal student loans. This legislation mandated that mortgage loan servicers grant forbearance for up to 180 days, with the option for an extension for another 180 days, to borrowers experiencing COVID-19-related financial hardship.²⁹, ³⁰ Under the CARES Act, no additional interest, fees, or penalties could be charged beyond what would have accrued if payments were made on time.²⁸

Key Takeaways

• Loan forbearance offers a temporary suspension or reduction of loan payments.
• It is a tool for borrowers facing short-term financial difficulties, preventing immediate delinquency or default.
• Interest typically continues to accrue during loan forbearance, which means the total cost of the loan may increase.
• Forbearance agreements require the borrower to repay the missed amounts at a later date through various options.
• The terms of loan forbearance vary widely depending on the type of loan and the lender's policies.

Interpreting Loan Forbearance

Interpreting loan forbearance involves understanding that it is a temporary bridge, not a permanent solution or loan forgiveness. When a borrower enters a forbearance agreement, it signals that they are experiencing a short-term financial challenge that impacts their ability to meet their debt obligations. For the lender, granting forbearance can be a form of loss mitigation, as it can be less costly than initiating foreclosure or pursuing collections on a defaulted loan.

Borrowers should interpret forbearance as an opportunity to stabilize their financial situation. It provides a crucial window to recover from a setback, such as job loss or unexpected medical expenses, without immediately damaging their credit score or risking the asset backing the loan, like a home in the case of a mortgage. It is crucial to understand the specific terms of the forbearance, including how and when missed payments, plus any accrued interest, will be repaid.

Hypothetical Example

Consider Sarah, who has a $200,000 mortgage with a monthly payment of $1,000 (including principal and interest). Due to an unexpected job layoff, Sarah experiences a sudden financial hardship. She contacts her loan servicer and requests loan forbearance.

Her servicer agrees to a six-month forbearance period, during which Sarah does not need to make any monthly payments. The loan has an annual interest rate of 4.5%.

1. Initial Situation: Sarah's monthly payment is $1,000.
2. During Forbearance: For six months, Sarah pays $0.
3. Interest Accrual: Even though payments are paused, interest continues to accrue. If her monthly interest portion was, for example, $750, then over six months, an additional $4,500 ($750 x 6) in interest would accrue and potentially be added to her principal balance or become a separate balloon payment.
4. Repayment Plan: At the end of the six months, Sarah finds a new job. Her servicer offers her a few options to repay the $6,000 (6 months x $1,000) in missed payments plus the $4,500 in accrued interest:
   • Lump-sum payment: Pay $10,500 immediately.
   • Repayment plan: Add an extra $350 per month ($10,500 / 30 months) to her regular payment for 30 months.
   • Loan modification: Adjust the loan terms to include the missed payments, potentially extending the loan term or increasing future payments.

Sarah chooses the repayment plan option, as it allows her to gradually catch up without a large upfront payment, making her monthly obligations manageable.

Practical Applications

Loan forbearance is primarily applied in situations where borrowers face temporary financial distress and need a short-term reprieve from their loan obligations. It is widely used across various types of loans:

• Mortgage Forbearance: This is perhaps the most common application, especially during large-scale economic disruptions like the COVID-19 pandemic. It allows homeowners to temporarily pause or reduce their mortgage payments, preventing foreclosure. The Consumer Financial Protection Bureau (CFPB) provides detailed guidance on mortgage forbearance options.²⁷ The Federal Housing Finance Agency (FHFA) also outlines options for deferring missed payments to the end of the loan.²⁵, ²⁶
• Student Loan Forbearance: Federal and private student loans often have forbearance options for borrowers experiencing financial difficulties, unemployment, or other qualifying events. Federal student loan forbearance generally allows a temporary postponement of payments for up to 12 months at a time.²³, ²⁴
• Auto Loan and Personal Loan Forbearance: While less standardized than mortgage or student loan programs, some lenders may offer forbearance options for auto loans or personal loans, typically on a case-by-case basis. These arrangements provide borrowers with flexibility during unforeseen circumstances.²²

These applications help borrowers maintain their financial stability during difficult times, ultimately benefiting lenders by reducing the likelihood of costly defaults and collections processes.²¹

Limitations and Criticisms

While loan forbearance offers crucial relief, it comes with limitations and has faced criticisms, particularly regarding its long-term impact on borrowers.

One significant limitation is that interest typically continues to accrue during the forbearance period for most loan types, including unsubsidized federal student loans and private loans.¹⁸, ¹⁹, ²⁰ This means that even if payments are paused, the total amount owed can increase, potentially leading to a higher principal balance and a greater overall cost of the loan. This capitalization of interest can make it harder for borrowers to get back on track once the forbearance period ends.

Another criticism emerged from the large-scale student loan forbearance programs during the COVID-19 pandemic. While these programs provided immediate relief, some research suggests that the temporary pause in payments, combined with improved credit score reporting, might have inadvertently led some distressed borrowers to take on more additional debt, such as credit card or auto loans, which later resulted in higher rates of delinquencies once payments resumed.¹⁷ There is a concern that while forbearance can be effective in the short run, it may not significantly reduce the probability of default in the long run for the banking system.¹⁶

Borrowers must actively manage their financial situation during and after forbearance, as the missed payments are not forgiven but merely postponed. Failure to arrange a suitable repayment plan with the loan servicer at the end of the forbearance period can lead to serious consequences, including renewed delinquency or even foreclosure.¹⁵

Loan Forbearance vs. Loan Deferment

Both loan forbearance and loan deferment offer temporary pauses or reductions in loan payments, providing relief to borrowers facing financial hardship. However, a key distinction lies in the treatment of interest accrual and the eligibility requirements, particularly for federal student loans.

With loan forbearance, interest generally continues to accrue on the loan balance during the period of paused or reduced payments. This accrued interest is then typically added to the loan's principal balance (capitalized) when the forbearance ends, increasing the total amount owed and potentially the future monthly payments.¹³, ¹⁴ Forbearance is usually granted at the discretion of the loan servicer or lender, often requiring a demonstration of financial difficulty.

In contrast, loan deferment, especially for certain types of federal student loans (like subsidized loans or Perkins Loans), can allow for a pause in payments where interest does not accrue.¹¹, ¹² This means the loan balance does not grow during the deferment period, making it a more financially advantageous option if a borrower qualifies. Eligibility for deferment is typically tied to specific qualifying events, such as enrollment in school at least half-time, unemployment, or active military service.¹⁰ For private loans and unsubsidized federal loans, interest usually still accrues during deferment.⁸, ⁹

While both provide temporary relief, deferment is generally more favorable if available, as it can prevent the loan balance from increasing due to accrued interest.

FAQs

Q1: Will loan forbearance hurt my credit score?

Generally, if you arrange for loan forbearance with your lender before missing payments and adhere to the agreed-upon terms, it should not negatively impact your credit score. Lenders typically report your account as current or in forbearance, which is not considered negative. However, if you stop making payments without a formal forbearance agreement, it will likely harm your credit.⁶, ⁷

Q2: Is loan forbearance the same as loan forgiveness?

No, loan forbearance is not the same as loan forgiveness. Forbearance is a temporary pause or reduction in payments, meaning you still owe the full amount of the loan, plus any interest that accrues during the forbearance period. Loan forgiveness, on the other hand, means that a portion or all of your loan debt is canceled.⁵

Q3: How do I request loan forbearance?

To request loan forbearance, you should contact your loan servicer as soon as you anticipate or experience financial hardship. Explain your situation and inquire about the available forbearance or loss mitigation options. Be prepared to discuss your financial circumstances, though for federally-backed mortgages under programs like the CARES Act, extensive documentation may not be required for the initial request.³, ⁴

Q4: What happens when loan forbearance ends?

When loan forbearance ends, you are typically required to resume making your regular monthly payments and make arrangements to repay the missed payments, including any accrued interest accrual. Your loan servicer will usually offer several repayment plan options, such as a lump-sum payment, a repayment plan over several months, or a loan modification that adjusts your loan terms.¹, ²