How many payments does it take?
Among the many challenges already facing borrowers that have taken advantage of payment deferments, another one they may not have foreseen is now emerging: balances that refuse to decrease even as regular payments are resumed.
Steve McCarthy, CFA
November 9, 2020
As months-long payment deferments granted early in the pandemic reach their end, borrowers are again resuming payments on their auto loans. So far, they have been managing to stay current at an encouraging rate, but there is cause for concern that this trend may be short lived.
ABS investors were pleasantly surprised to see performance hold up even months after the federal supplemental unemployment benefit that many borrowers were relying on expired. A new policy brief published by the JPMorgan Chase Institute, however, warns that the buffer borrowers managed to build up early in the pandemic by socking away this money is now quickly depleting. To make matters worse, as these borrowers struggle to come up with the funds to stay current on their loans, an additional and likely unexpected factor may further discourage them: loan balances that remain unchanged even as they continue to make their full payments on time each month.
No free lunch
To borrowers, besides a reprieve from payments, the most apparent consequence of a payment deferment is the extension of the loan's maturity date by the same number of months for which payments are deferred. These deferments, however, also come with a more insidious side-effect: the continued accrual of interest during the deferment period.
As a result of this accrued interest, even if the borrower were to make all of their scheduled payments after the extension period ended, they would still have an outstanding balance at the time the loan matured. Further, once the borrower resumes payments, the interest accrued during the deferment period must be paid back first before any portion of the payment may be applied to the principal still outstanding. In fact, some subprime borrowers who received a payment deferment will need to make at least 12 scheduled payments—a year's worth—to pay down the interest that accrued as a result of the deferment, all the while their principal balance will remain unchanged.
Quantifying the payback period
The number of payments required to resume principal paydown on a loan that has been extended can be computed using a familiar formula:
k ∙ [(1 + c)r - 1]
- k is the number of months the loan was extended
- c is the monthly interest rate (annual interest rate / 12)
- r is the loan's remaining term
As the above formula illustrates, while the number of payments required to resume principal payments increases linearly with the number of months the loan is extended, it increases exponentially relative to the interest rate and remaining term of the loan. At the extreme, a borrower that received a 4 month extension on a 30% APR loan with 72 months remaining would need to make 20 regular monthly payments before any portion of their payments would be applied to the principal balance.
Payback periods in practice
Fortunately, most servicers did not grant protracted extensions at significant rates since the pandemic began, and the few public ABS deals that did see 4 month extensions comprise only prime borrowers. Because loans in these pools will have lower interest rates and shorter remaining terms (due to both shorter original terms as well as higher seasoning at issuance), they do not exhibit high rates of long payback periods.
Filter shelves
Of all public prime issuers, Ally Financial's (ALLYA) pools now have the longest average payback periods, with 1.7% of borrowers needing 3 or more months to resume paying down their principal (assuming borrowers neither make payments during the extension period nor pay more than their scheduled amount once monthly payments resume). Subprime borrowers, on the other hand, with higher interest and extension rates as well as longer remaining terms, will be far more impacted by this phenomenon. While only 3% of AMCAR (GM Financial's subprime shelf) borrowers--who we previously noted were granted extensions at a much lower rate during the pandemic than those of other subprime issuers--will need to make 3 or more payments before resuming principal pay downs, almost one third of Santander Consumer's deep subprime DRIVE shelf borrowers will not see their principal outstanding reduced across the same number of payments. At the extreme, nearly 1% of DRIVE borrowers will need to make 12 or more regular payments before seeing their balance outstanding budge.
As illustrated in a February 2019 report published by Kroll Bond Rating Agency that found extended borrowers were four times more likely than 30-day delinquent borrowers to perform on their loans over the next twelve months, extensions have been an effective tool to help borrowers through periods of temporary hardship. Of course, caution must be used when comparing payment deferments offered since March to those prior to the pandemic, considering deferments have never been offered at this scale or to so many borrowers that have never taken advantage of one in the past. Additionally, so many borrowers' incomes now also seem to hinge on short-term government policy decisions that have proven unpredictable, to say the least. This uncertainty, plus a loan balance that seems stalled at the same amount despite the resumption of regular monthly payments might prove to be too much for many borrowers.
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