Updated on: August 29, 2020 ; Wealth & Value
What is moratorium?
Before we start our discussion on moratoriums, let’s have a look at loans. You must be familiar with the concept of loans and its basic workings. Normally a bank lends money to a borrower for a certain period.
The lender (the bank) charges interest on the money lent. This interest could be either at a fixed or floating rate. The amount lent is known as the principal amount. The time for which the money is lent is known as the duration of the loan.
The borrower then needs to pay back the bank a certain amount every month, known as EMI (Equated Monthly Installments). Compounding is applied to compute the EMI, which accrues each month.
Hey, why are we talking about loans when we are supposed to discuss moratoriums?
Moratoriums are closely tied to loans. Let’s see how. The borrower needs to keep paying the EMIs without fail until the repayment is complete. Missing any payment can prove very costly to the borrower. There are financial, legal, and credit rating costs.
This EMI holiday is known as Moratorium. It is not a waiver of EMIs. You will have to pay for it eventually. The outstanding loan increases by the missed payments. The borrower will have to pay back this amount and also the additional interest accrued on it.
We will discuss all of it in detail in this article with some examples.
Why do you need moratorium?
There might be economic downturns or personal financial difficulties, where you could face some short term cash crunch. During such periods a break from paying your EMIs could be a much-needed relief. You can use the additional cash saved on other essential expenses and resume paying your EMIs when your financial condition improves.
Banks provide the moratorium option to its borrowers on special occasions. It is completely up to the borrower, whether to opt for it or not.
Should you opt for a moratorium?
As I mentioned before, moratoriums come at a cost. Nothing comes for free and so does moratoriums. If you opt for loan moratoriums, you will have to pay more than the original payment schedule. This is because the EMIs you chose to pay later get added to your outstanding loan amount. In addition to that, you will also need to pay the interest on this additional amount.
So you need to understand these costs before you decide on whether to opt for the moratorium or not. Now, these added costs can either increase your EMIs keeping the number of EMIs the same a before, or it can result in a higher number of EMIs keeping the EMI amount unaltered.
In the following sections, we will explain the scenario of increased number of EMI payments. We will illustrate this with a few examples of different loan tenures and different moratorium periods. So let’s get started with the examples.
Example 1:
We will start with a simple example. Let’s assume that you took a loan of 1,00,000 rupees. The tenure of the loan is for 12 months, and the bank is charging a 10% rate of interest.
The EMI for this loan comes out to be 8,791.59 rupees. The break-up of the monthly principal and interest components are provided in the table below:
You can notice that the principal component increases and the interest component decreases as we move forward in time. Next, let’s see what happens if you opt for a 3 months moratorium at the beginning of the payment schedule. The table below illustrates the monthly payments for such a scenario.
The first three rows are the moratorium period, where you do not make any payments. So the interest to be paid gets added to the principal remaining. Unlike the previous case, the interest to be paid keeps increasing until you start making payments. This is because the unpaid interest gets added to the principal remaining, and the new interest is computed on this increased principal amount.
Once you start making the payments, the interest component starts decreasing. Now, notice the last four rows. You would have had to pay the additional 3 months (months 13, 14, and 15) of EMIs, as you had skipped the first three payments. This was expected. But you would also have to make an additional payment of 2,808.07 rupees in the sixteenth month. So you end up paying 2.8% (2,808/1,00,000) extra in the end. This is the additional cost you would have to bear if you had opted for the moratorium option.
Now, let’s look at a slightly different scenario to explore how does the cost of moratorium change under different circumstances.
Example 2:
In this example, we will modify the previous example a bit and analyze the impact on the payment schedule.
We will explore the case where the same loan is given a moratorium of 6 months. The table below shows the monthly payment schedule for the 6-month moratorium scenario.
We will directly go to the last row here. You will end up paying 5,686.93 rupees more in the 19th month. The 6 months moratorium would cost you 5.68% extra at the end of the 19th month.
So, your cost would increase with an increase in the moratorium period. Let’s explore the impact on higher tenure loans in the next section.
Other Examples:
By now, we have developed a good understanding of the impact of moratoriums on the payment schedule. So we won’t be looking at any more detailed tables. We will focus on the summary of different scenarios for longer tenure loans.
The table below summarizes the 3-months moratorium and 6-months moratorium scenarios for tenures of 5, 10, and 20 years loans.
The table above is self-explanatory. Do you notice how the cost increases substantially with an increase in tenure? In the case of a 20-year loan, you would end up paying 20% (20,208.9/1,00,000) of your loan amount as an additional cost of a 3-month moratorium. You will have to make this excess payment, over the period of an additional 21 months, almost 2 years.
Compared to that, a 6-months moratorium on a 20-year loan would cost you 45,372 more, 45% of the loan amount. In addition to that, your 20 years loan will become a 24 years loan as 4 years gets added to your payment schedule
Conclusion:
Moratoriums are short term relief that cost you more in the long term. Avoid them as far as you can. Only opt for them if you are under severe financial stress. The examples above clearly state that longer the term, higher is the cost.
Manage your finances well!