Dubai: Borrowers facing budget constraints following the recent weather conditions in the UAE were offered an option by the Central Bank on Monday to put a pause on their monthly dues for up to six months after checking with their banks and insurers.
Also referred to as a ‘repayment holiday’, loan deferments is a widely used alternative that allows you to temporarily pause your loan payments with the lender's approval. But when should you consider choosing the option? Is it always cost-effective to do so? UAE banking experts evaluate.
“Although it is a short-term solution, deferring your payments can help keep your accounts in good standing while you get back on your feet. However, this option isn't guaranteed for everyone,” explained Abbud Sharif, a banking industry analyst based in Dubai.
“Banks offer this option to mostly those who are struggling financially by giving them the chance to temporarily press pause on their loans. A case in point being the 2020 pandemic crisis where job losses or salary cuts made it difficult for global residents to make up their monthly due payments.”
The addition of unpaid interest to the principal balance (borrowed amount) of your loan is termed ‘interest capitalisation’. The principal balance of a loan increases when payments are postponed during periods of deferment and unpaid interest is ‘capitalised’.
But there are instances where interest doesn’t accrue during such periods like student government loans in the US, for instance. Also, interest didn’t add up in the loan deferment from when the COVID-19 crisis impacted customers, or won’t accrue for the loan pause option announced now in the UAE.
Interest accrues in most other loan deferrals
“At times when lenders avail such a waiver on borrower debts, there are many who defer their loans even when they are able to currently meet their financial obligations, thinking they can utilise this chance to get a temporary relief on to their monthly debt payments,” Sharif added.
“But this isn’t as great an idea as one might think. Banks evaluate each borrower’s ability to repay to determine whether or not a loan deferral affects interest accrued during the paused term. This is what most do not take into account and why many are quick to avail of loan deferment options.”
What this means is that the interest you accrue while you’re not making payments will still be added to your loan balance each month. So, before we go any further understand that this is only a grace period, not a waiver of the loan.
Let’s say you have a Dh350,000 mortgage or home loan and normally pay Dh729 in interest each month. This amount will still be added to your loan each month it’s paused, which is called ‘capitalising’ the interest on your loan.
What happens when loan interest accumulates?
“When you don’t pay monthly instalments (EMIs) of your loan, banks are most often obligated to charge interest for the unpaid amount. Missing two instalments extends your loan by 6-10 months or increase EMI amount by about 1.5 per cent,” explained Jose Paul, an Abu Dhabi-based banker.
“However, in a typical real world EMI scenario, a deferment should extend the loan only by the number of instalments deferred. EMIs are inclusive of interest and principal components. So, a few deferrals won’t involve interest capitalisation and reformatting of payment schedule.
“But if the borrower is going for a restructuring of the loan that involves change in tenure and EMI, it will have implications in terms of rate changes. Or, your minimum repayment after the repayment pause will be higher, you pay more interest in the long term if you do take a repayment holiday.”
‘Only pause loans if it’s absolutely necessary’
Sharif and Paul both agreed borrowers should only pause loans if it’s absolutely necessary. “Remember, the longer the remaining tenure, bigger the impact. This is as the interest accounts for a larger portion of the EMI in the early years and progressively comes down,” added Sharif.
“It is however important to note that after the first year, the interest accounts for almost 80 per cent of the EMI. But towards the end of your long-term loan, let’s say in the 20th year, the interest portion is less than 10 per cent in the EMI.
In other words, people with loans taken say 10 to 15 years ago will not feel the burden as much as someone with a new loan taken just a few years back. What this implies is that people with older loans may not really need the moratorium as much as those with younger loans.
“So, opt deferment only if there is a dire need. If you can afford to pay the EMI, don’t opt for the moratorium. Now, if you’re wondering why interest still accrues and not cancelled, remember that as banks operate like any other business, forgoing repayments is unsustainable,” Sharif said.
• Let’s say interest accrues in April and May, then the borrower can make a one-time payment in June.
• The interest is added to the outstanding loan, which will increase the EMI for the remaining months.
• The EMI is kept unchanged but the loan tenure is extended. The number of additional EMIs will then depend on the age of the loan.
Bottom line?
Pressing pause is also not the only option if you’re struggling to pay your loans. “You could also reduce your payments for a period to help you through tough times rather than pausing the full loan repayment. Stopping or reducing your payments may help you avoid default,” added Sharif.
“You could sometimes also access funds in your redraw facility if you’re ahead on your payments. Switching to interest-only payments for a period of time to reduce financial stress could also be an option.”
What financial advisors often recommend is avoid making deferment-related queries if your financial situation hasn’t changed. “With banks doing all they can to help people with genuine needs, if you don’t need help, leave your lender’s resources free for those who need them,” Sharif said.
It’s also vital to know you won’t automatically be offered the chance to press pause on your loan. “Offering a pause is at the lender’s discretion. Banks are businesses and they need weigh up the risk of offering a pause to customers who are not in a position to sustain a loan long term,” added Paul.
“You will get short-term relief if your bank approves you to pause your loan. But if your situation doesn’t change, you do need to have a financial plan beyond six months. This is because there’s currently no talk of extending this period of leniency beyond that time.”
The key takeaway is always make sure to keep your bank fully informed of your financial position if you are struggling with your repayments and ask about any assistance that’s available.
