What Is a Default?
Default is the failure to make required interest or principal repayments on a debt, whether that debt is a loan or a security. Individuals, businesses, and even countries can default on their debt obligations. Default risk is an important consideration for creditors.
Key Takeaways
- A default occurs when a borrower stops making required payments on a debt.
- Defaults can occur on secured debt, such as a mortgage loan secured by a house, or on unsecured debt, such as credit cards or a student loan.
- Defaults expose borrowers to legal claims and may limit their future access to credit opportunities.
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Understanding a Default
A default can occur on secured debt, such as a mortgage loan secured by a house or a business loan that's secured by a company's assets. The loan could go into default if the borrower fails to make timely payments and the asset or collateral that was used to secure it would be in jeopardy. A company that's unable to make required coupon payments on its bonds would also be in default.
Defaults can occur on unsecured debt as well, such as credit card balances. A default reduces the borrower's credit score and can limit their ability to borrow in the future.
Defaulting on Secured Debt vs. Unsecured Debt
Its lenders or investors may sue to recover the funds when an individual, business, or country defaults on a debt. Their recovery prospects will depend in part on whether the debt is secured or unsecured.
Secured Debt
The bank may ultimately foreclose on a home that secures a mortgage if the borrower defaults on the mortgage. The lender can repossess the vehicle if a borrower defaults on an auto loan. These are examples of secured loans. The lender has a legal claim to a particular asset that's acquired with a secured loan.
Corporations in default on secured debt may file for bankruptcy protection to avoid forfeiture, providing time for negotiations on a settlement with creditors.
Unsecured Debt
A default can also occur on unsecured debt, such as medical bills and credit card balances. Unsecured debt isn't backed by an asset but the lender still has a legal claim in the event of a default. Credit card companies often wait a few months before sending an account into default.
The debt would be "charged off" after six or more months without payments being made on an outstanding balance. The lender would write it off as a loss and close the account on a debt that's been charged off. The creditor may then sell the charged-off debt to a collection agency, which would then attempt to collect from the borrower.
A collection agency that buys a charged-off, unsecured debt can have a lien or judgment placed against the borrower's assets. A judgment lien is a court ruling that gives creditors the right to take possession of a debtor's property if the debtor fails to fulfill contractual obligations.
Defaulting on a Student Loan
Student loans are another type of unsecured debt. Defaulting on a student loan has the same consequences as failing to pay off a credit card, affecting your credit score, your credit rating, and your future loan prospects. Those who default on federal student loans may also face wage garnishment.
First You’re "Delinquent"
Your loan is officially delinquent when your payment is 90 days overdue. It's reported to all three major credit bureaus so your credit rating will fall.New credit applications may be denied or approved only at a higher interest rate that can be charged to riskier borrowers.
A bad credit rating can follow you in other ways. Potential employers and potential landlords often check the credit scores of applicants, especially employees who will need a security clearance to perform the job.
Next, You’re "in Default"
The loan will end up in default if your payment is at least 270 days late. About one third of all federal student loan borrowers have been in default at some point.
Borrowers who don't enter a loan rehabilitation agreement with Default Resolution Group at the department's Office of Federal Student Aid can eventually be subject to withholdings of tax refunds and other federal payments, as well as garnishments of up to 15% of their take-home pay.
You can enter the federal student loan rehabilitation program or use loan consolidation if your federal student loans are in default.
Deferment or Forbearance
A good first step is to contact your lender as soon as you realize that you may have trouble keeping up with your payments. The lender may be able to work with you on a more attainable repayment plan or help you obtain deferment or forbearance on your loan payments.
Temporary Aid for Student Loan Borrowers
Student loan payments and the accumulation of interest on outstanding loans were suspended by the Department of Education (DOE) as a COVID-19 relief measure. The DOE then extended the pause on federal student loan payments in November 2022 in response to a federal court order blocking the White House’s student loan forgiveness plan.
Student loan payments were scheduled to resume 60 days after the department was permitted to implement the program or the litigation was resolved. Student loan interest charges then resumed on Sept. 1, 2023 and payments restarted in October 2023.
The DOE launched the "Fresh Start" initiative in April 2022 which helps borrowers in default keep some benefits while getting out of default. The temporary program will last until September 2024 unless extended. Collections were stopped, you could apply for federal student aid, and your loan would be reported as "current" rather than "in collections" on your credit report.
Sovereign Default
Sovereign default occurs when a country doesn't repay its debts. A country that's in default usually cannot be compelled to satisfy its obligations by a court, unlike an individual or corporate debtor. But it does face a variety of other risks and problems. The economy might go into recession or the currency might devalue. The defaulting country may be shut out of debt markets for years to come.
Sovereign default can occur for a variety of reasons, including political unrest, economic mismanagement, or a banking crisis. Greece defaulted on a $1.73 billion payment to the International Monetary Fund (IMF) in 2015 before securing additional debt relief from the European Union.
Fitch, a leading provider of credit ratings, downgraded the U.S. credit rating from AAA to AA+ on Aug. 1, 2023. It indicated that it foresees "fiscal deterioration" over the next three years and cited the federal government's tendency for last-minute negotiations over the country's debt ceiling. The U.S. Budget Committee has indicated that this is only the second time in the nation's history that a credit rating provider has taken this action.
Defaulting on a Futures Contract
Defaulting on a futures contract occurs when one party doesn't fulfill the obligations set forth by the agreement. Default usually involves a failure to settle the contract by the required date in this case.
A futures contract is a legal agreement for a future transaction involving a particular commodity or asset. One party to the contract agrees to buy at a specific date and price and the other party agrees to sell at the contract-specified milestones. They could face collections actions and lawsuits if one party defaults.
What Happens When You Default on a Loan?
When a borrower defaults on a loan, the consequences can include:
- Negative remarks on a borrower's credit report and a reduced credit score, which is a numerical measure of a borrower's creditworthiness
- Reduced likelihood of obtaining credit in the future
- Higher interest rates on any new debt
- Garnishment of wages, a legal process that instructs a third party to deduct payments directly from a borrower’s wages or bank account, as well as other penalties.
A default will stay on your credit reports and be factored into your credit score for seven years, according to the credit bureau Experian.
A Real World Example
Puerto Rico defaulted in 2015 when it paid only $628,000 toward a $58 million bond payment. Damage from Hurricane Maria in 2017 then exacerbated the island's economic and debt crisis.
Puerto Rico announced plans to cut its debt to roughly $86 billion from $129 billion in 2019 in the largest bankruptcy in U.S. history. The bankruptcy filing was authorized under a 2016 law passed by Congress. The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) also established a financial board to oversee the territory's public finances.
A U.S. judge approved a restructuring plan in early 2022 that cut Puerto Rico's $70 billion public debt to $37 billion as part of the bankruptcy process.
What Happens When You Default on a Payment?
Your account is ultimately sent to a debt collection agency that tries to recover your outstanding payments when you default on a loan. Defaulting on any payment will reduce your credit score, impair your ability to borrow money in the future, lead to charged fees, and possibly result in the seizure of your personal property.
How Long Does a Default Stay on Your Credit Report?
Defaults stay on your credit report for seven years. A default may be removed earlier if it can be proven that it was a mistake. Your credit score should improve after the default is removed.
What Is an Example of a Default?
A default is a missed payment or multiple missed payments on money that you've borrowed. An example of a default would be not paying your credit card bill or your monthly mortgage payment.
The Bottom Line
Default is the failure to make required interest or principal repayments on debt. Individuals, businesses, and countries can default on debt obligations. Failure to meet payments on a mortgage, student loan, or personal loan will affect an individual's credit rating, their ability to secure future loans, and could result in the seizure of property or wages.
Corporations can default by failing to meet coupon payments on bonds. Sovereign default occurs when a country doesn't repay its debts.
