The Coronavirus Aid, Relief, and Economic Security (CARES) Act, and the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus issued March 22, 2020, support financial institutions considering loan modifications—whether at borrowers’ requests, by statutory mandate, or initiated by financial institutions as borrower-relief programs.
Learn more about practical accounting considerations associated with payment deferrals, which have been a commonly discussed modification for borrowers during the COVID-19 pandemic.
Accounting for Interest During Payment Deferral Periods
The question that arises on payment deferrals is whether interest should continue to accrue during the payment deferral period.
The interagency guidance issued on March 22, 2020 indicated if a loan was current at the time of a modification, then the loan should be considered current during the deferral period. Loans with short-term modifications discussed in the guidance generally shouldn’t be reported as non-accrual.
However, the guidance indicated lenders should look to regulatory instructions, as well as US Generally Accepted Accounting Principles (GAAP), when determining accrual status.
When payments aren’t made ratably over the life of the loan—which would be the case when a payment deferral exists as part of a loan modification—interest may continue to accrue, subject to the lender’s evaluation of collectability.
Here are questions to consider when you’re determining whether interest accrual during a deferral period remains appropriate:
- Based on all currently available information, is the borrower capable of repaying the loan, including all accrued interest, according to the modified terms of the loan?
- As the payment deferral period progresses or ends, do updated evaluations of the borrower’s capability to make all payments, according to the modified terms of the loan, lead the lender to believe interest and principal are all collectible?
If the answer to both questions is yes, then continuing to accrue interest is appropriate.
If not, interest accrual should cease until such time that the lender’s current analysis of collectability supports resumption of interest accrual.
Application of Payments After Expiration of Payment Deferral Period
Once the deferral period expires and payments resume, the next question becomes how lenders should treat the balance of interest that accrued during the deferral period once payments resume.
Whatever approach an institution takes, which could vary on a loan-by-loan basis, management should consider the approach before entering into the modifications. State, local, and other laws and regulations should be considered by the institution when developing its strategy.
Make sure to work with borrowers so that repayment expectations are clear at the onset of the modification, and the modifications reflect the most likely scenario where the borrower can repay the modified loan as agreed.
Below are different approaches lenders can take, each with their own benefits and risks.
Recover Interest First
The first, and potentially most common approach, would be to use payments to recover any accrued interest first before paying down principal. Once accrued interest is repaid, payments will return to contributing to principal and interest.
This approach is straight forward and is likely most familiar to borrowers. The payment amounts remain the same, but the maturity date extends a bit longer than the deferral period.
Defer Interest Collection
Another option would be to add the repayment of the interest that accrued during the payment deferral to the end of the loan, either as a balloon payment or an increase to an existing balloon payment.
This approach could create a number of questions the lender needs to determine:
- Is interest that accrues during the deferral period still classified as accrued interest receivable?
- Or, should it be presented as a loan or other receivable?
- If interest doesn’t accrue on this balance, should the balance be written-down through the allowance to the net present value?
- How is the balance tracked?
- Can the loan subsidiary ledger track the balance or does that function need to be performed manually?
One benefit for the borrower is they wouldn’t have to repay the balance until the end of the loan, and their payments would remain the same each payment period.
Re-Amortization
A lender could capitalize the interest that accrues during the deferral period into the loan. Then, the lender would update the payment amounts to facilitate the loan amortizing to zero, or the original balloon amount, at maturity.
This approach doesn’t extend the loan longer than intended, or require a new or increased balloon payment at the end.
However, it would increase the monthly payment for the borrower, which may be contrary to the original intent of providing financial assistance through use of the deferred payment period.
Re-amortization could also result in negative loan amortization during the deferral period, if the interest is capitalized into the loan, which could cause unfavorable regulatory and accounting treatments for the lender.
Delinquent Payments and Hedged Loans
Institutions should consider the appropriate accounting treatment if the borrower is unable to make payments once the deferral period ends.
The loan is technically current during the deferral period. If the borrower misses the first payment after the deferral period, they would only be one payment behind contractually. However, they wouldn’t have made a payment for over six months.
Institutions should evaluate these delinquencies for nonaccrual status differently than the standard 90 days past due approach.
Additionally, institutions engaged in balance sheet hedging or swaps on loans need to evaluate the contracts to see if modifying the terms of a hedged loan would have accounting or contractual implications, or impact the effectiveness of the hedge.
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Navigating the complexities of interest accrual and application of payments by borrowers is highly dependent upon specific facts and circumstances. If you need assistance evaluating these facts and circumstances, contact your Moss Adams professional.