Default

Default
To default means to fail to repay a loan or line of credit. A borrower can default on their loan if they fail to pay back either the principal loan amount or the interest.

What is a Default?

To default means a borrrower has failed to repay a loan or a line of credit. If a borrower defaults, it is because they have not paid their loan back according to the terms of the agreement with their lender. A borrower’s inability to make payments on either the principal loan amount or the interest that the loan has accrued can result in default.[1]

Typically, a borrower won’t default after failing to make a single payment on time. Usually, one late payment will result in an extra fee being charged to the borrower. If the payment is late enough, it could also result in a derogatory mark being made on that borrower’s credit report. The point at which a default has occurred will vary between lenders, contracts, and types of loans.

While defaulting on a loan will result in a derogatory mark being placed on the borrower’s credit report, there are other consequences that will depend on the type of loan that was made.

How does Default work with a secured loan?

A secured loan is a loan that comes with collateral. Collateral is a piece of valuable property that the borrower puts up to ensure the lender against a loss if the borrower cannot repay. Should the borrower default on their loan, the lender can seize the collateral and sell it in order to recoup the money that they lost. Examples of secured loans include mortgage loans (which are secured by real estate), auto loans (which are secured by motor vehicles), and pawn shop loans (which are secured by valuable personal items such as jewelry or home electronics).

When a borrower defaults on their mortgage, their collateral real estate is placed into a process called foreclosure. When a borrower defaults on their auto loan, the lender can seize their car, truck, SUV or motorcycle through a process called “repossession.” On the other hand, when a borrower defaults on their pawn shop loan, there is no process by which the lender needs to seize the property. This is because pawn shop lenders actually hold onto the collateral until the loan is fully repaid. If the borrower defaults, all the pawn shop needs to do is place the item out for sale.

How does Default work with an unsecured loan?

An unsecured loan is any kind of loan that does not involve any kind of collateral. These loans are approved and issued based solely on the borrower’s ability to repay. (To be exact, the loans are approved based solely on whether or not the lender believes that the borrower will be able to repay.) The majority of personal loans and student loans are unsecured.

Lenders who issue unsecured loans will usually look at a borrowers’ credit report, credit score, and debt load before approving the loan. Those factors can also help determine what kind of interest rate the borrower is charged. The better a borrower’s perceived creditworthiness, the lower the interest rates they will qualify for.

When a borrower defaults on an unsecured personal loan, it is much more difficult for the lender to recoup the amount of money they have lost. This is why unsecured loans often come with higher interest rates than secured loans and usually require a higher credit score. A lender who has had a borrower default on a loan can try to collect on the debt, which might result in the lender taking the borrower to court and eventually garnishing their wages.

The lender can also sell the debt to a debt collections agency – oftentimes for pennies on the dollar – and write the loss off on their taxes. The debt collections agency can then also attempt to collect on the debt and even take the borrower to court.[2]

How will Defaulting on a loan affect my credit?

Defaulting on a loan will affect your credit negatively. It will leave what is called a “derogatory mark” in your credit history, which will then end up on your credit report.

Credit reports are records of a person’s history of credit use that are compiled by the three major credit bureaus: Experian, TransUnion, and Equifax. The information on your credit report generally goes back seven years. It will contain information about how much debt you currently owe or have owed in the past, your history of on-time payments, whether or not you have ever filed for bankruptcy, and, yes, whether you have ever defaulted on a loan.

The information on your credit report is used to determine your credit score, which has a very important effect on what kind of loans and credit cards you can qualify for, what kind of apartments you can rent, and even, in some cases, what kinds of jobs you can be hired for. The most common kind of credit score is the FICO score (which is created by the FICO company). FICO scores range from 300 to 850. The higher the score the better your credit.

The derogatory mark created by defaulting on a loan or credit card could cause your FICO score to drop significantly. It would then take seven years for the mark to drop off your credit report entirely and cease negatively affecting your credit score. Some lenders, such as payday or title lenders, do not report payment information to the credit bureaus. However, these lenders are often known for their incredibly high interest rates, misleading terms, and aggressive collections or repossession practices.

What are some methods to prevent Defaulting on a loan?

People who are at risk of default should talk to a HUD-approved credit counselor. That counselor can then help them create a budget and take better control of their personal finances. The counselor might even be able to put them on a Debt Management Plan (DMP).

Under a DMP, the credit counselor negotiates with a person’s creditors (ie, the people and institutions to whom they owe money) in order to secure more favorable terms. This could mean an extension of the loan’s term or a lowering of loan’s interest rate. The one thing that a credit counselor will not negotiate under a DMP is a reduction in the principal amount owed.[3]

Once a borrower’s creditors have agreed to these new terms, the borrower will then make monthly payments to the credit counselor, who will pay all of the creditors. DMPs last until the borrower’s debts are entirely paid off, which usually means a period of three to five years. While the borrower is under the DMP, they are prohibited from taking out any new forms of credit.

A person at risk of default could also attempt creating a budget on their own to reduce their spending. If that is not enough, they could also try taking on a second job to increase their income. A person could even try and negotiate with their creditors directly in order to secure more favorable terms or reduce the amount they owe.

References:

  1. “Default.” Investopedia. Retrieved November 4, 2016 from http://www.investopedia.com/terms/d/default2.asp.
  2. Fontinelle, Amy. “How the Debt Collection Agency Business Works.” Investopedia. Retrieved March 15, 2016 from http://www.investopedia.com/articles/personal-finance/121514/how-debt-collection-agency-business-works.asp.
  3. Detweiler, G. “Does Credit Counseling Work?” BusinessInsider.com. Retrieved November 4, 2016, from https://www.businessinsider.com/does-credit-counseling-work-2011-4.