What is forbearance and how does it work?

Falling behind on your monthly payments for a loan can have drastic long-term implications. You will lose the asset that you put as collateral such as a home, and your credit rating will suffer, rendering you unable to take out a new loan for years. You may be dragged into legal disputes by your lender. For that reason, borrowers want to avoid the nightmare of defaulting on a loan.

Borrowers who are struggling financially have many options to get out of their difficult situation. Forbearance is one of them. While forbearance agreement is available for many types of loans, it is particularly popular for mortgages and student loans. It is considered one of the best solutions for homeowners whose difficult financial situation is temporary and when they want to avoid paying mortgage installments just for a short period of time.

What is forbearance?

There are many circumstances in life when borrowers go through a short-term financial crisis. What if you were laid off? You are sure that you will find a new job in a couple of months, but due to your strained financial situation, you are not able to keep up with monthly loan payments when you are unemployed. The same holds true when a borrower can’t work temporarily due to illness or injury.

In these situations where financial problems are temporary, you can take advantage of forbearance benefits. Before you go into default, you can talk to your lender and have the payments suspended or reduced for a given period of time. Your lender can not initiate foreclosure proceedings against you during the forbearance period. The borrower agrees to get current with the payments missed during the forbearance period.

They include:

• Principal amount
• Interest amount
• Private mortgage insurance (if applicable)
• Taxes

To enter into a forbearance agreement, you have to approach your lender before missing any payments and negotiate the terms and conditions including the maximum period for which your lender will allow to suspend or reduce payments or any additional penalties and taxes that may apply. Keep in mind these terms and conditions may vary from lender to lender.

But what happens if you are unable to pay the missed payments in full at the end of forbearance period? Well, some lenders will extend the forbearance period; others won’t and may proceed to foreclosure. Again, policies differ from lender to lender, and it depends on a lot of other factors such as your credit score and income history.

Mortgage forbearance agreement

As the name suggests, this agreement applies in situations when a borrower is a homeowner who wants to suspend or reduce mortgage payments. Going into default may result in foreclosure, so a homeowner facing temporary financial hardship can avail forbearance benefits.

Keep in mind that lenders are not in the business of real estate, most of them would happily work with a struggling borrow to avoid foreclosure. When agreeing to a foreclosure agreement, they would take into consideration several factors including:

• The total amount of loan due
• Various terms of the mortgage you agreed to at the time of signing the loan documents
• Interest rate etc.

Forbearance Terms

You should pay attention to what terms and conditions are you committing to when signing a forbearance agreement.

Here are a few factors which will have a bearing on your agreement:

• As already explained, since terms vary from lender to lender, you should find out the general terms and conditions specified by your bank.
• Forbearance terms are not set in stone. A lot will depend on negotiation between you and the lender.
• The lender would evaluate your financial situation and then determine whether you would be able to make timely payment of monthly installments after the end of the forbearance period.
• It is up to the lender whether they completely defer all the payments including principal and interest or they allow only a partial reduction. You can also negotiate accordingly if you only need partial help. You can choose to keep paying the interest amount.
• Forbearance period also varies. It could be anywhere from three months to one year.
• You may not be eligible for forbearance if you have an adjustable-rate mortgage with very high-interest rate (at the time you are seeking forbearance).

Steps to entering forbearance

1. First of all, you will approach the lender before missing any payments.
2. You will have to provide an explanation, backed up by satisfactory proof, as to why you want to enter forbearance.
3. The lender will examine your payment history (whether you have a history of missing payments) and your ability to catch up at the end of the forbearance period. If you have had a study job in a high-demand sector, the chances of your application being approved will increase substantially.
4. You will sign a forbearance agreement.

Difference between forbearance and loan modification

Not that you know what forbearance is, you can easily understand what distinguishes it from other types of foreclosure alternatives. One such popular option among struggling homeowners is a loan modification.

In a loan modification agreement, your lender doesn’t suspend or reduce your payments for a short period of time, rather changes the terms of the loan to make the payments more affordable.

This can be done in any of the following ways:

• The amortization period will be increased. Let’s say you were supposed to pay off the mortgage in 15 years. While modifying your loan, your lender will increase the length of the loan term to 30 years.
• If you took out the mortgage with a variable interest rate, your lender can convert it into a fixed-rate mortgage.
• The interest may be lowered, subject to the current market rates.
• You will be asked to provide sufficient proof of your current financial hardship. The documents your lender would want to take a look at including your current credit score, income and expense statements, tax returns, credit card statements, bank statements etc. You will also be asked to provide a letter proclaiming your financial hardship. Some lenders ask borrowers to go through a trial period to demonstrate that they would be able to keep up with the modified installment amount.

In the U.S., while most private lenders allow borrowers to modify their loans, the federal government also runs many programs to help homeowners avoid foreclosure. The Home Affordable Modification Program (HAMP) is one such program that is part of the federal government’s Making Home Affordable initiative.

Contrary to forbearance, a loan modification agreement works in situations where the financial hardship is long-term, and the borrower won’t be able to keep up with the current loan installment amount in the near future.

The forbearance terms and conditions explained above in this article are mostly applicable in the U.S. Different countries have different types of forbearance terms in place.

Spain

The Bank of Spain – the county’s de facto bank – prohibits regulated financial institutions from maintaining a mortgage in arrears. Any change in the terms and conditions of the mortgage agreement can convert it into a new mortgage, causing tax known as AJD and Notary and Land Registry costs to be incurred.

But many Spanish banks allow temporary interest-only payments for struggling homeowners. The only catch is that these changes in the agreement should not cause any changes to the mortgage deed. In Spain - like many other countries – the loan should not be already in arrear for the borrower to get a forbearance relief. Spanish banks are not obliged to provide any relief to borrowers who have gone into default.

Australia

Forbearance is part of what is known as hardship variation in Australia. Hardship variation is offered to homeowners struggling financially. It gives them two alternatives – they can ask for lower payments by changing the term of the loan (known as loan modification in the U.S) or they can suspend the payments for a few months altogether (known as forbearance in the U.S.).

The borrower can even take advantage of both the benefits – he or she can have the payments reduced and at the same time get a few installments suspended. The borrower has to apply to an external dispute resolution scheme to get hardship variation relief.

Conclusion

Which option you should opt for to avoid going into default depends on your financial situation and an array of other factors. In most situations, forbearance has little to no impact on your credit score, particularly if you didn’t miss any payments and pay off the due amount at end of forbearance period.

The option of forbearance is in every way better than other foreclosure alternatives such as short sale and bankruptcy which may stay on your credit report up to seven years in countries like the United States. It is important that you enter into a foreclosure agreement before missing an installment, so you should get in touch with your lender as soon as you realize that you won’t be able to keep up with monthly payment temporarily due to certain circumstances such as loss of job or injury.

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