What Happens When You Default on a Loan?
The Consequences of Breaking Your Lender's Trust
Sometimes your finances don’t work out as planned. You probably intend to pay off all of your loans promptly, but life can surprise you in a number of ways—a job change or health event can quickly throw you off track. So, what happens in those worst-case-scenarios? Eventually, you may “default” on your loans, and it’s important to know how that affects your financial health.
What Does It Mean to Default on a Loan?
Simply put, a loan enters default when the borrower fails to pay the lender after a certain amount of time, according to terms in the initial loan agreement. The timeframe before default kicks in can differ from one loan to another, but in all cases it's a threshold that, once crossed, comes with undesirable consequences.
When you first took out a loan you signed a contract which laid out the terms and rules for payments. If you miss a payment (or two) other penalties may be enacted before your loan will fall into default. For example, you may incur fees, and your loan may be designated as "delinquent," but in most cases you can return to good standing by making a full payment within a reasonable amount of time. How long? It could be 30 days, or 60, or longer, but it ultimately depends on the agreement, so it's important to read the fine print. And if you can't pay on time per the terms in the contract? Then you are officially in default.
General Loan Default Consequences
Not surprisingly, if you default on a loan, you have breached a contract with your lender, and this comes with consequences. Defaulting sends a red flag to other financial entities that you are not a reliable borrower, and in some cases may not be trustworthy in other financial aspects as well.
Damage to Your Credit
When you fail to make required payments, your credit will suffer. Your credit score is made up of many factors, but the most significant is your payment history. This includes all outstanding accounts, loans, credit cards, or other lines of credit, and your standing in each.
Some lenders report delinquencies if you're late on a bill, but for the first 30 days after a payment is due, you’re probably in the clear. Without a doubt, missed payments that lead to default will be reported to credit bureaus, resulting in lower credit scores.
Low credit scores make it difficult to secure loans in the future, and low scores can impact several other areas of your life. For example, you might have a harder time renting, finding a job, signing up for utilities and mobile phone service, and buying insurance.
To make matters worse, your debt burden will probably grow if you default on a loan. Late payment fees, penalties, and legal costs might be added to your account, increasing the total balance you owe.
In fact, considering the effects of compound interest, your debt might grow quickly. When you miss payments, your monthly interest charges are added to the principal balance of the loan; the following month you'll be charged more interest on this greater balance, which can quickly snowball.
When all else fails, lenders send unpaid debts to collection agencies. Collections damage your credit, can result in legal judgments against you, and can be expensive. In some unfortunate instances, debt collectors can be quite a nuisance too.
Consequences Based on Loan Type
Depending on the type of loan you have, defaulting can lead to additional specified consequences. Some loans come with a built-in set of remedies for default, and some rely on trust alone.
If a loan was secured with collateral, like your home or car, the lender can potentially reclaim that property. Defaulting on secured loan acts as a trigger for the lender to seize the collateral to make up for your unmet debt.
If you default on a car loan, for example, the vehicle can be repossessed and sold. You might also be liable for a difference in value if the car sells for less than you owe (which can happen due to quick depreciation, or if you’ve somehow managed to go upside-down on the loan). Repossession is possible for the original loan you used to purchase the vehicle and any title loans you’ve taken for extra cash.
Mortgages are another form of secured loans, with your home as collateral. Defaulting on a home loan is severe, as your lender might be able to force you out through foreclosure and sell your home to collect the loan balance. Similar consequences apply if you refinanced your home, or borrowed against it with a home equity line of credit or second mortgage. Plus, if the sale doesn’t cover the entire amount you owe, you might still owe the difference or “deficiency,” depending on state laws.
In the wake of COVID-19, the Federal government enacted legislation to create various forms of debt relief through the CARES Act and subsequent amendments. Homeowners benefit through forbearance and foreclosure protections through June 30, 2021, with provisions specific to each state.
For unsecured loans (which have no linked collateral), lenders can only damage your credit and try to collect by taking legal action.
Federal student loans are unsecured, since the lender offers them on faith alone. Federal student loans are relatively borrower-friendly, and offer multiple repayment or postponement plans if you fall on hard times, but if you default you can lose those options. In lieu of collateral, the Federal government lender may impose additional consequences of student loan default:
- The IRS can withhold tax refunds to pay off the debt.
- The Department of Education can garnish your wages very easily.
- The Social Security Administration can lower your payments.
The CARES Act included provisions to offer relief to student loan borrowers as well. Federal student loans went into automatic forbearance, with no interest accrual, and all collection activities on loans in default were stalled through September 30, 2021.
Credit cards also fall into the category of unsecured debt. Defaulting on a credit card loan is probably the most painless type of default, but your credit will certainly suffer, and your account will likely be sent to collections. Expect to see fees added to your debt, and collection agencies will make endless phone calls and other attempts to collect.
How to Avoid Defaulting on a Loan
Though it may be tough to make payments if you're suffering financially, it’s much harder to clean things up after you cross the default threshold. Here are a few strategies if you think you may be close:
- Contact your lender. Communication is essential when you run into financial trouble. Let your lender know if you’re struggling to make payments. Taking a proactive stance to work out a solution demonstrates good faith as a borrower.
- Document everything. If you can work an “arrangement,” be vigilant in documenting all communication, and get agreements in writing. Assistance programs require details, and careful records may help clear up potential disputes down the road, such as in credit reporting.
- Take advantage of student loan relief options. Federal student loans enter default after 270 days of missed payments. That's a lot of time to explore whether you qualify for deferment, forbearance, income-based payments, or any other arrangements that make it easier to pay.
- Modify your mortgage. Rather than defaulting on your home loan, seek out alternatives such as loan modification or refinancing, which may help lower your monthly payments. There are also several government programs designed to help homeowners in trouble.
- Meet with a credit counselor or financial professional. It might be helpful to talk with a licensed credit counselor who can help you evaluate your financial position and even set up a debt management plan (if it's appropriate in your situation).
In sum, going into default on your loans can feel devastating, and should be avoided at all costs. However, there are multiple methods to stay in good standing with your lender, and help is available. With a bit of premeditation, you can avoid loan default and its nasty consequences.