Student loans are not as rare a concept as it used to be decades ago. Now more than ever, with the increased competition among the new generation to be the best which includes having a sound educational background, comes the need to borrow student loans to facilitate it. Qualifying for a student loan, be it federal or private is not very difficult if you comply with the basic eligibility criteria. What comes next is the challenge, repayment of the loan. And in this situation arises the concept of forbearance which we will learn about in detail.
Table of Contents
- Meaning of forbearance
- Types of forbearance
- Qualification for forbearance
- Forbearance and credit score
- Alternative options
What is the meaning of Forbearance?
Forbearance can be defined as an agreement between a lender and a borrower to temporarily suspend or reduce debt payment by delaying it. It is a form of loan assistance. The borrower, though willing to make the loan payments, but is unable to do so for certain reasons owing to financial hardships, can be granted a forbearance by the lender.
For student loans, the unpaid interest that continues to accrue during the forbearance will be added to the principal balance of the loan(capitalized), in turn, increases the total amount of money owed when you switch out of forbearance and enter back into the payment plan.
Handling the interest accrued during the forbearance
You have the choice to either pay the interest as it accrues or allow it to accrue and be capitalized at the end of the period. That means unless you make payments that cover the interest while in forbearance, your balance will be higher when your loans re-enter repayment. Essentially, you’ll be expected to pay interest on the interest that accrued. Student loan repayment is quite tricky but if handled well it can be beneficial for the borrower as he can increase his credit score by making on-time payments.
Forbearance can be as short as a few months or as long as a year and sometimes more. Federal student loans are usually eligible for forbearance whereas private loans may not be, but it varies from lender to lender, so you will need to check with your lender.
In most cases, if your lender allows you to consolidate your loans into one, then that consolidated loan may only be eligible for limited forbearances — such as shorter forbearance periods — or none at all. Unpaid interest is capitalized only on Direct Loans and FFEL Program loans.
An example will aid you better in understanding how it works.
For example, say you owe $20,000 at a 5% interest rate, qualify for forbearance requiring no payments for a period of an entire year, and no interest is paid during that time. At the end of the forbearance period, you will owe $21,000. Interest will then further be calculated on this larger principal amount.
Let us take a closer look at the various aspects to be considered before entering into a forbearance period -
Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments to the lender by forcing the sale of the asset used as collateral for the loan.
To understand it better in context; for mortgages, lenders may opt to foreclose on borrowers who are unable to make payments. To avoid a costly foreclosure, the lender and the borrower can negotiate a forbearance agreement to allow the borrower to catch up on payments.
When you refinance student loans, a private lender pays off your existing loans and replaces them with one loan with a new interest rate and a new repayment schedule.
Add on interest loan
This is a lending arrangement in which
(1) the total interest over the loan's entire duration is added to the principal at the time of signing the loan documents, and
(2) a fixed portion of every loan repayment installment goes towards interest payment.
Since this arrangement does not take into account the reducing principal balance, it results in an actual (effective) interest rate that is much higher than the quoted interest rate. In fact, the more frequent the repayment installments, the higher the effective interest rate. In the modern legal lending practice, the effective interest rate (called 'annual percentage rate' or APR) must be disclosed by the lender at the time a loan application is accepted.
Add on interest
Add-on interest is a type of interest that is calculated at the start of a loan. It is then applied to the principal, or amount borrowed. This form for interest ensures that all interest is repaid even if the borrower pays off the loan earlier than the expected due date.
Length of time/Duration of forbearance
You can usually apply for a forbearance period of up to 12 months over the life of the loan, although this will vary by in terms of type of the loan. Some lenders offer forbearance in three-month increments, and they may limit maximum forbearance time depending on the type of hardship you experienced.
Types of Forbearance
Forbearance is broadly divided into two types -
Let us look at them in detail -
1) General Forbearance
General forbearances are available for Direct Loans and FFEL Program loans. Here, your loan servicer has the entire discernment to decide whether or not to grant your request for a general forbearance This is why a general forbearance is also called a ‘discretionary forbearance.’ In other words, discretionary forbearance means you are the mercy of your lending institution.
The borrower can request forbearance over the phone or in writing. If requested over the phone, the lender will send the borrower a notice confirming the terms of the agreed forbearance within 30 days. It is the responsibility of the borrower to review the notice to ensure that the terms reflect the agreed-upon forbearance.
You can request a general forbearance if you are temporarily unable to make your scheduled monthly loan payments for one or more of the following reasons:
Change in Employment/ Unemployment
And any other reason that is acceptable to your loan servicer.
If you are still experiencing difficulties when your current forbearance expires, you may request another general forbearance. . There is no fixed cumulative limit on general forbearance for Direct Loans and FFEL Program loans, but your loan servicer may set a limit on the maximum period of time you can receive a general forbearance.
2) Mandatory Forbearance
Under mandatory forbearance, once you meet the eligibility requirements, your loan servicer is required to grant the forbearance.
This type of forbearance is generally used in several situations. You are eligible for a mandatory forbearance if you’re:
If you are enrolled in a medical or dental internship or residency program and meet the requirements
The amount owed each month in total is 20% more of your total gross monthly income for a period of 3 years
You are serving at a national service position such as the AmeriCorps for which you had received a national service award
You have qualified for a teacher loan forgiveness by providing service as a teacher
You have qualified for partial repayment of your loans under the US Department of Defence Student Loan Repayment Program
You are a member of the National Guard and have been activated by a governor but have not qualified for a military deferment
Mandatory forbearance may be granted for no more than 12 months at a time. If you continue to meet the eligibility requirements for the forbearance when your current forbearance period expires, you may request another mandatory forbearance.
There are nevertheless, certain special cases in which your loan servicer can place your loans in forbearance without requiring you to fill out a form. Instead, a verbal agreement, or sometimes even no direction at all will suffice.
For example, natural disasters often result in borrowers being unable to make payments. The department often offers forbearance for victims of federally declared natural disasters so those borrowers don’t have to worry about repayment as they get their life back in order.
Additionally, your servicer may place your account in forbearance for a variety of reasons. While servicers are processing applications for repayment plans, they may put your account in forbearance so you don’t have to make payments that you may not be able to afford.
How do I qualify for forbearance?
The eligibility of the borrower is decided by the loan servicer. You have to meet certain standards set by the lender, as we have seen above. Furthermore, There are detailed situations in which the borrower can be counted as qualified for forbearance. In most cases, that means you must be suffering some kind of hardship, although lenders differ about what qualifies as a hardship. The following situations give a more specific understanding:
Financial hardship, like unemployment, underemployment, reduced income, business failure
Increased expenses, such as increased property taxes or mortgage payments
Disaster, both natural and man-made, whether insured or not
Separation from a co-borrower, such as a divorce or any other kind of relationship in which one or more people make loan payments
Medical hardship, such as long-term disability or serious illness, including when suffered by someone you care for
Death of a co-borrower or the primary or secondary wage earner in your household
Relocation or transfer for your job, including going on active duty in the military
Any other reason, provided you can prove that it causes you hardship
Deferment and forbearance are available for federal student loans but are usually not available for private student loans. If you are not sure about what category your loan falls in, you can have it checked and tracked on the National Student Loan Data System.
Also, deferment and forbearance are not available if you're in default on your federal student loans.
How does forbearance affect my credit score?
Forbearance can initially hurt your credit. But, your credit is not affected during the period your forbearance is in effect. While applying for forbearance may temporarily lower your credit score, it won’t harm your credit as bad as delinquency or default. For that reason, if you think you’re going to default on a loan, always explore more by asking your lender for your options first.
Yes, having something affect your credit score is not something you voluntarily would want, but it is comparatively better than losing your home or having your wages garnished as a result of falling behind in your payments for too long.
Worried about college tuition? Learn about student loans
Alternative options to forbearance
Forbearance, as discussed earlier, is just a temporary suspension or reduction of debt payments. If you need a longer-term solution, you might need to look into other repayment plans. The following are some of the options available to you for federal loans:
Income-driven repayment plans calculate your payment based on your income, so you never have to pay more than 10% of your discretionary income. Your payment term is extended to 20–25 years, but at the end of that term, if there is any balance left, it will be forgiven.
The extended repayment plan simply extends the loan term to up to 25 years, lowering your payments but increasing the amount of interest you pay overall.
The graduated repayment plan retains the standard 10-year term, but makes the first payments low, increasing them every two years so you fully pay off the loan within 10 years. We only suggest this plan if you predict steady pay increases to keep up with the loan payment increases.
This brings us to a safe closing thought that if you ever find yourself in a situation where you need to postpone repayment – forbearance is a decent option to consider but everything said and done, there are some bargains and it is good practice to keep in mind that delaying payment can come at an additional cost. Since forbearance does not pause the loan completely and the interest keeps accruing, it should only be used if you are having a temporary problem making payments and are looking for a short-term solution.
The terms of the forbearance agreement depend on the lender, but it may not be your best choice if you consider and qualify for other types of loan modifications, such as income-driven repayment, deferment, or cancellation. Even though the terms for forbearance are not as favorable as a deferment, forbearance is definitely a better option than the end result of default if you're in financial distress.