Dealing with The Consequences of Loan Deferrals When the Deferral Period Ends

With many Canadians facing a cash crunch during the COVID-19 lockdown, a quick-fix solution has been to defer debt payments.

Here are some fast facts about how popular loan deferrals were with Canadians:

• Close to 1 million¹ mortgages were deferred.
• More than $1billion² in mortgage payments were deferred each month.
• Mortgages accounted for just 27% of accounts³ deferred in May 2020.
• Credit cards represented another 32% of account deferrals³
• Auto loans accounted for 10% of accounts deferred³
• 12% of accounts³ deferred were installment loans
• 13% of deferral requests³ were for open creditor accounts like cell phones

But what are the long-term consequences to your finances if you get a loan deferment? How do you recover when the payments finally come due?

What does a loan deferral mean?

A loan payment deferral means you skip payments for a short time, a month, or up to six months. During the deferral period, interest continues to accrue on the principal balance of the debt. The missed principal payments will need to be caught up eventually.

Deferring a debt payment can free up cash in the short-term. Payment deferrals provide support when you are experiencing financial hardship like many are right now due to Covid-19. A deferral can take the pressure off your budget, and help you pay for necessities like rent and groceries and reduce the risk that you technically default on your mortgage or loan.

Deferrals are not new. Many institutions have offered one-time deferrals. Your mortgage may have a skip a payment clause, for example. Financial institutions have expanded these normal programs allowing those who experience financial difficulties due to COVID-19 to postpone principal and interest payments during the crisis.

A deferral is not debt forgiveness

A debt deferral is not debt forgiveness. You still owe both the loan and the deferred payment amount. While banks may allow you to skip payments for a few months, they will expect full repayment after your deferral period is over, and with additional interest charges. A loan deferral delays payments, it does not eliminate payments.

What happens when payments start up again?

Deferred mortgage payments

Mortgage and loan deferrals add to your future financial costs because interest continues to accumulate during the deferral period, and this unpaid interest will be added to the principal owing. You will also need to catch up on the suspended principal payments at some point.

The best thing to do is have a plan before your deferral ends. You have several repayment options:

• Some mortgage lenders give you the option of paying the accrued interest once payments resume.
• You can add the unpaid interest to your loan or mortgage balance. For example, if you defer six months’ payments on a $400,000 mortgage at 3.5%, your new mortgage balance will be $406,904.11 at the end of the deferral period. This will increase your future interest costs and monthly mortgage payments.
• Most lenders will automatically increase your monthly payment to account for this higher balance and accumulated interest to ensure you repay the loan in the same amortization period.
• An option is to extend the term of your loan to keep your payments where they were, but this means paying more interest over time.

A payment deferral means trading future cash flow for current cash flow. Scotiabank has estimated that the average monthly mortgage payment for deferral customers will increase by $60 over the life of the loan.

The real issue is who will be able to afford to catch up on these deferred payments once the COVID-19 provisions end? The economy is not going to magically return to normal even after we restart. While I’m not an economist, in all likelihood, I expect we are in for a slow climb.

It is highly likely that most homeowners will opt to add unpaid interest to their mortgage balance. Most were off work and needed the deferral to stay afloat, so it is unlikely they will have the money to make a lump sum or balloon interest payment.

Credit card deferrals

Credit card deferrals are an even greater concern. Most, but not all, Canadian banks will reimburse 50% of the interest charged or lower the interest rate during the relief period for those who qualify, however, the accrued interest will still mean higher balances and higher minimum payments for many once the deferral ends. Our average client owes almost $15,000 in credit card debt at the time of insolvency.  At a half-rate of 10% for three months, that adds $450 to their debt load.

Will you have the capacity to repay? Some will, many will not. Those most at risk of job losses when the economy shut down will see the slowest return to economic prosperity. Some sectors, like retail, service, and hospitality jobs, will take the longest to rebound. These are also lower-paying occupations, so many will not be able to catch up on deferred payments quickly, if at all. In the Q12020 report, TransUnion predicts that in a worst-case scenario, credit card delinquency rates will increase by 38%.

Car loans

Again, individual agreements vary but in most cases car lenders will extend the term of your loan for the number of months deferred. Because you did not make payments during the deferral period, your loan balance remains higher for longer resulting in higher interest. Your auto lender may increase your monthly car loan payment to account for this interest or add this as an additional payment at the end of your car loan.

Payday loans

An unexpected product for which borrowers can receive a deferral is a payday loan. So far, we have identified one lender offering payday loan modification agreements, and we would not be surprised if other payday lenders were providing a similar agreement to their borrowers.

Making payday loan or high-cost predatory installment loan payments is already difficult. Deferring these payments will make debt elimination virtually impossible.

Student loans

In March 2020, both the federal and Ontario government announced a temporary and automatic deferral of student loan payments between March 30, 2020, to September 30, 2020. In this time, student loan borrowers will not be required to make any loan payments, and interest will not accrue on their student loans.

While there is no added monetary cost to deferring a government student loan, a deferral extends the length of time you have student debt. Delay making your student debt payments by half a year may help with cash flow, but if jobs don’t return, repaying student debt will even harder than it was before the recession.  Prior to COVID-19, roughly 1 in 5 insolvencies involved student debtors, and this number was rising. I expect the deferral will only delay a spike in student debt insolvencies in the next two to three years.

Tax obligations – a hidden deferral

If you are collecting the Canadian Emergency Benefit (CERB) or the Canada Emergency Student Benefit (CESB) it is important to know that, while the government does not deduct taxes from your payments at source, CERB and CESB are considered taxable income. You must report these payments as income on your 2020 tax return.

For many, this will be a hidden deferral payment they will have to catch up on. Come next year, you may be facing tax owing rather than your normal tax refund. I recommend setting aside 20-30% now (the equivalent of your effective tax rate) to pay these future taxes. You can calculate your effective tax rate by taking last year’s taxes and dividing by your taxable income.

Debt deferrals and credit reporting impact

Most lenders have set up special reporting with the credit bureaus to avoid having a deferred payment show up as a missed payment. Instead, they are marking payments as deferred due to the coronavirus.

While this avoids a severe hit to your credit report, there are still some longer-term consequences.

• Your credit score is based on a number of factors, payment history is just one. Higher balances post COVID can negatively impact your credit score. Debt deferrals lead to higher debt balances and higher utilization rates, both of which can lower your score.
• We do not know yet just how lenders will view this ‘deferral’ when granting new credit in the future. It is still an indication that you were experiencing financial distress.
• We have heard that mortgage lenders are confirming income, even on renewals, indicating that credit may tighten in the coming months.

Recently, one unfortunate student debtor discovered her government loan payment was incorrectly reported delinquent by RBC to TransUnion. This incorrect report damaged her credit score. For this reason, we strongly advise you to keep copies of any correspondence with your lenders about the deferral process. If your lender agrees to let you skip a payment, ensure you have the agreement in writing. You will be much more likely to resolve a credit report dispute if you have proof of a deferral agreement.

How to deal with deferred payments when your deferral period ends

The idea of a deferral sounds easy, but you need to think through the consequences and make a debt repayment plan. You can use our free debt repayment worksheet to get started.

As with any debt repayment program:

• Build a budget based on your expected return to work and future income. Be realistic.
• Focus on your highest cost debt first. It may be OK to let your mortgage payments increase and repay that deferral over time if that means getting your credit card debt balances down sooner.
• If you’ve cut back on spending during the lockdown, keep up those spending savings until you pay down your COVID related debt.
• Make additional lump sum payments any time you can.
• If you found your car loan or lease to be too costly or the deferral means you owe significantly more than the car is worth, consider surrendering the vehicle to lower your future payments.
• If you can’t pay your deferred mortgage payments, you can extend the amortization to lower payments and if that does not work, you may have to make the tough choice to sell your home.
• If you can’t afford to resume payments, contact your lender right away and discuss options like refinancing or an extended deferral. Recognize this may just postpone the problem.
• See if there are options to lower your interest rate. Ask your lender for an interest rate reduction or look into alternatives like a consolidation loan.
• File a consumer proposal.

If you found yourself deferring so much debt and you can’t see yourself paying back your balances, consider talking with a licensed insolvency trustee about making a deal with your creditors to repay what you can.

These are unprecedented financial times. Deferrals will help many Canadians through, and the vast majority will have the resilience to recover. However, if you can’t, know that you are not alone. If you’d like to chat about your situation, please give us a call. We are here to help.

References:

1. Canadian Bankers Assocation https://cba.ca/fast-facts-on-bank-measures-in-response-to-the-covid-19-pandemic
2. CMHC https://assets.cmhc-schl.gc.ca/sites/cmhc/data-research/publications-reports/residential-mortgage-industry-report/2020/residential-mortgage-industry-report-2020-en.pdf
3. TransUnion Q2 2020 Financial Services Canada Industry Insights Report

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