What is a Grace Period?
The term “grace period” refers to the passage of time that straightaway follows the repayment deadline for any financial obligation during which the borrower can make the payments without incurring any late fees or any other consequences due to failure to meet the deadline. Typically, most mortgage loans, insurance contracts, and credit card bills offer a grace period. Sometimes grace period is also referred to as the forgiveness period.
It is important to highlight that the grace period shouldn’t be confused for either moratorium or deferment, which refers to the time period during which a borrower can breach the repayment deadline due to sudden unfavourable business events resulting in temporary financial hardships.
How does Grace Period work?
During this period, borrowers or customers are allowed to postpone their payment obligations for a brief period of time past the actual due date. As a result, the lenders or creditors don’t charge any late fees, and the delay isn’t construed as defaults, which means that the credit history of the borrowers or customers remains unblemished.
When the payment obligations are met within the grace period, then only the late fees are waived off, but in some cases, the interest continues to accrue on the outstanding balance. Hence, it is important to know the clauses around the grace period. For instance, most credit cards don’t charge any interest during the grace period, while some loans charge accrued interest.
Example of Grace Period
Different examples are mentioned below:
Let us take a simple example to understand the concept of the grace period. Let us assume that recently David availed of a credit card with a $10,000 limit. The due date for its monthly repayment is the last date of every month. However, he has a grace period of 21 days as per the agreement. So, he can make the credit card payment as late as the 21st of every month without incurring any late fees or additional interest.
Let us look at another example with more details. On March 1, 2020, Jonathan availed of a loan worth $50,000 in order to fund his business growth. The following are the important terms & conditions of the loan agreement:
- Monthly principal repayment of $1,000 is due on the 7th of every month;
- A 14-day grace period from the due date, i.e. repayment by the 21st of every month;
- A late of $500 to be charged if the repayment obligation isn’t met by the end of the grace period;
- A weekly interest rate of 10% of the monthly repayment obligation if not paid in full by the due date.
Determine the repayment obligation of April 2020 if the repayment is made on
- 7th April 2020
- 14th April 2020
- 21st April 2020
- 28th April 2020
- a) If the repayment is made on 7th April 2020, then only monthly principal repayment has to be done, i.e. $1,000 only.
- b) If the repayment is made on 14th April 2020, then monthly principal along with one week’s interest has to be paid, i.e. $1,000 + 10% * $1,000 = $1,100.
- c) If the repayment is made on 21st April 2020, then monthly principal along with two week’s interest has to be paid, i.e. $1,000 + 2 * 10% * $1,000 = $1,200.
- d) If the repayment is made on 28th April 2020, then monthly principal, two week’s interest, and late fees has to be paid, i.e. $1,000 + 2 * 10% * $1,000 + $500 = $1,700.
So, it can be seen how the repayment obligation varies as we move from the due date to the end of the grace period. Hence, it is advisable to meet the repayment obligations well within the due date and only resort to a grace period if there is absolutely no way.
Some of the major advantages are as follows:
- People, who are timely in their repayment, can continue to maintain their clean credit record even when they fail to meet the financial obligations on a rare occasion due to some special circumstances.
- It helps in avoiding penal interest and reputational damage provided that the obligation is fulfilled within this period.
- If paid within the grace period, the delayed payment isn’t considered as default.
- At times, firms use liquidity offered by the grace period for funding other short-term business requirements.
Some of the major disadvantages are as follows:
- It can end up encouraging the habit of procrastination.
- People who frequently utilize the grace period remain exposed to the risk of default due to unforeseen circumstances.
Some of the key takeaways of the article are:
- It is used by borrowers or customers to defer payment obligations without any negative impact.
- Many financial instruments come with a built-in clause.
- It shouldn’t be confused with deferment or moratorium, during which the lender may forgive some portion of the borrower’s repayment obligation owing to some temporary financial hardships.
- It helps borrowers avoid penalties, reputational damage, and the tag of being a defaulter.
So, it offers flexibility to the borrowers to defer payment obligations beyond the due date without incurring any additional costs. In other words, it is can be seen as a helping hand for those borrowers who are going through short-term hardships. But it is important that it doesn’t give way to lackluster credit behavior among the borrowers.
This is a guide to Grace Period. Here we also discuss the definition, working, and examples along with advantages and disadvantages. You may also have a look at the following articles to learn more –