Grace period on a loan: how it works and what it costs
What a grace period is, the difference between paying the interest and letting it pile up, an example with numbers and what to check in the contract.
A grace period is a stretch at the start of a loan in which you do not repay the principal. It can ease a tight beginning, such as a business that has not started to earn, a home still being built or an income that arrives later, but it does not make the loan cheaper: the interest keeps running, and the total you pay goes up. This guide explains what changes and what to look for in the contract.
What the grace period is
During the grace period the installments of principal wait. What happens to the interest depends on the contract, and that is the part that matters most. Once the grace period ends the regular installments begin, and what you repay is the original amount plus any interest that was added to it during the wait.
Two ways to handle the interest
- Pay the interest during the grace period: each month you pay only the interest for that month. The balance does not grow, and the debt at the end of the grace period is the same as at the start.
- Capitalize the interest: you pay nothing during the grace period and the interest is added to the balance. The balance grows, and from then on interest is charged on that larger balance, which is interest on interest.
An example with numbers
A loan of R$ 20,000.00 at 1.8% a month in PRICE, with 24 installments and a grace period of 3 months before them:
| Measure | No grace | Grace, interest paid | Grace, interest capitalized |
|---|---|---|---|
| Paid in each month of grace | — | R$ 360.00 | R$ 0.00 |
| Installments after the grace | 24 | 24 | 24 |
| Last installment | R$ 1,033.50 | R$ 1,033.50 | R$ 1,090.52 |
| Total interest | R$ 4,806.76 | R$ 5,886.76 | R$ 6,170.64 |
| Total paid | R$ 24,806.76 | R$ 25,886.76 | R$ 26,170.64 |
Paying the interest costs R$ 1,080.00 more than having no grace period, which is exactly the three payments of R$ 360.00 (1.8% of R$ 20,000.00). Capitalizing costs R$ 1,363.88 more, which is R$ 283.88 above paying the interest: the interest on the interest that was added to the balance. The effective cost rate is the same in all three cases, 23.87% a year, because the rate did not change. What grows is the amount, because you owe the money for longer.
When a grace period helps, and when it hurts
It helps when the budget really is tight now and will not be later: an income that has not started, an asset that is not yet producing. It hurts when it only postpones a payment the budget could already bear, because the cost is certain and the benefit depends on the situation improving. Capitalizing is the heavier option, so if you can pay at least the interest, it costs less.
How long a grace period you need
Count the months until the income, or the asset that will pay the loan, starts to produce, and ask for that and no more. Each extra month of grace has a price. With the interest paid, it is the monthly interest (R$ 360.00 in the example above). With the interest capitalized it is more, because the balance on which interest is charged keeps growing. A grace period longer than you need is a cost with no benefit. When two offers differ in grace, compare them by the total paid as well as by the total effective cost: the effective cost shows the rate, and the total shows for how long you owe it.
What to check in the contract
- Whether the interest during the grace period is paid or capitalized.
- How long the grace period is and whether it counts inside the term or comes before it.
- Whether the installments after it are recalculated, and what the new first installment will be.
- Whether insurance, fees or other charges are collected during the grace period.
- Whether you can pay more than the minimum, or settle early, without a penalty.
In the United States and Europe
The grace period has other names outside Brazil, but the choice between paying the interest and capitalizing it is the same. In the United States, federal student loans have a six-month grace period after the student leaves school, and on unsubsidized loans interest accrues during that time. On mortgages, a period in which only interest is paid, an interest-only period, keeps the loan from being a qualified mortgage, the category with the most legal protections. In Spain, grace periods are common on mortgages and on official credit lines for businesses: in a partial grace period you pay only the interest, and in a total one you pay nothing and the interest is added to the balance. In every case, the effect on the cost is what the table above shows.
How to simulate it
In the simulation, open the advanced options, enter the number of months of grace and choose whether the interest is capitalized. The schedule shows each month of the grace period and the first installment that follows, and the total interest and the total effective cost update. To see how the rate basis and the charges change the result, read about the total effective cost, nominal and effective rates and PRICE or SAC.
This guide is educational and informational. It is not financial, legal or investment advice and it does not know your situation. Example figures are illustrative, and rules change: check the current ones before deciding. Legal Notice