When you take out a loan for a car, home, or any other type of personal loan, you are promising the financial institution to pay back the money according to the terms of the loan. Sometimes, things don't always go as planned, and people may find themselves unable to make their payments on time. If this happens to you, you are at risk of defaulting on your loan. A loan is in default if the borrower stops making payments on the loan. Defaulting on a loan can damage your credit score, making it more difficult to qualify for loans or better rates in the future.
What is a loan default?
What does it mean to default on a loan? A borrower defaults on a loan when they stop making payments on their loan. For most loans this means the borrower hasn't made several consecutive payments, breaking the terms of the agreement. The point when a loan is considered to be in default depends on the type and terms of the loan.
Loan defaults can happen with any loan, such as a mortgage, auto loan, credit card, or personal loan. Lenders will consider the loan to be in default if the minimum required payment is not paid for a certain time period that is specified in the agreement. The time period is typically one to nine months, depending on the type of loan. So if a borrower fails to make their car payments for several months in a row, then they have defaulted on their loan.
What happens if you default?
When a loan is in default, most lenders will require the borrower to pay the entire loan amount and interest immediately. Depending on the type of loan, the lender may seize any secured collateral or you may be taken to court and have your wages garnished. If there is a lawsuit, any judgment against you may be public record.
Payment history makes up 35% of your credit score, so defaulting on a loan will have serious consequences. A loan default will remain on your credit report for up to seven years. This can impact your ability to get any future mortgages, auto loans, and credit cards. If you do qualify, your interest rate will likely be very high. A low credit score can also hurt your chances of getting insurance, utilities, or approval to rent an apartment. Many employers also conduct credit checks before hiring an employee.
On top of this, the lender or collection agencies will continue to call and request payment from borrowers who have defaulted on their loans. They will continue to pressure you until the debt is paid off or threaten to take legal action.
Defaulting on a secured loan
A secured loan is backed by collateral such as a car or house. Defaulting on a secured loan means the lender will seize the collateral to pay off the loan. If you default on an auto loan, the lender will repossess the car. In the case of a home, the lender will foreclose on it.
The financial institution would then try to sell the asset to recoup their losses. If the collateral is not enough to pay off the loan, the lender may try to collect the remaining balance from you. In the rare case that the collateral is worth more than the loan, the lender may give you the surplus. In any case, defaulting on a loan will damage your credit score.
The most common types of secured loans are:
- Mortgage
- Auto loan
- Secured personal loan
- Secured business loan
Defaulting on an unsecured loan
An unsecured loan is not backed by an asset but it is backed by the borrower. Lenders will attempt to collect the remaining loan payments. If they are unable to do so, they typically send your loan to a collection department. In some cases, they may sue and attempt to garnish wages or put a lien on any property you may have.
The most common types of unsecured loans are:
- Credit cards
- Unsecured personal loan
- Unsecured business loan
What is the difference between default and delinquency?
A loan is delinquent if you have missed a payment but have not defaulted on the loan yet. Delinquency begins the first day after the due date. The loan then becomes delinquent or past due. The period of delinquency can last one to six months, depending on the loan terms.
Borrowers will usually be charged a penalty fee and the lender will contact the borrower to collect the payment. If the borrower makes the payment then the loan will be considered in good standing. If the lender has been unable to collect the loan payment while it is delinquent, then the loan will be considered in default.
Lenders will usually contact the credit bureaus to report a loan that is delinquent. The lender will send notifications to the borrower to let them know the loan is delinquent. If the lender is unable to do so, it will sell the debt to a collection agency and the collection agency will send notifications about the loan.
What is a grace period?
Some lenders will give a grace period if a payment is late. A grace period gives the borrower a short time period to repay the loan after the due date. There are no penalties incurred during this period. The loan however, will continue to accrue interest. Here are the typical grace periods for the different loan types. Keep in mind that the grace period varies based on the terms of your loan and yours may be different.
| Loan Type | Length of Time Before Loan Is in Default | Grace Period |
|---|---|---|
| Mortgage | 30 days | 15 days |
| Auto | 30 days | 10 days |
| Credit cards | 180 days | Period between end of billing cycle and payment due date |
| Personal loans | 30 days | 15 days |
Data source: Info compiled by author from various sources.
How to avoid defaulting on a loan
Some people may forget they have a loan or a payment due and not realize they are in default before it is too late. Set up reminders for all of your loans. You can set up autopay so the payment is automatically made.
If you are unable to afford your current loan payments due to financial issues or other emergencies, contact the lender and explain your circ*mstances. Do this before the due date, do not wait. Ignoring your lender is the worst thing you can do.
The lender may restructure the loan to help make the payments more manageable. It may also enroll you in a forbearance or deferment program. A forbearance program will allow you to postpone paying your loans, but the interest will continue to accrue. In a deferment program, interest will not accrue on your loan balance.
Other options you can take are debt consolidation programs, working with a credit counselor, refinancing your current loans, or transferring your debt to lower interest credit cards. You generally have to have good credit in order to use these alternatives. The key is to be proactive in managing your payments. Communicate with the lender so it does not report any late payments on your credit report. Many lenders are willing to work with you to avoid a loan default.
How to recover from defaulting on a loan
Recovering from defaulting on a loan can be challenging, but it's not impossible. Try to pay off any outstanding balances on the loan and bring it up to date. The first step in the process is to assess your financial situation and determine how much you owe.
Once you know your total debt, you can begin to create a plan to repay it. This may involve negotiating with your lender, seeking assistance from a financial counselor, or developing a strict budget to increase your ability to make payments.
In addition, you may want to consider rebuilding your credit history, which can help you qualify for future loans. Recovering from defaulting on a loan is a gradual process, but with time and effort, you can get back on track and work toward achieving your financial goals.
This will help improve your credit score and demonstrate to future lenders that you are capable of repaying your debts. Additionally, you can consider working with a credit counselor to reduce your debt and improve your credit management skills.
FAQs
If a payday lender attempts to withdraw money from a closed checking account, you may be subject to overdraft fees from the bank or additional fees from the lender. The bank may also keep the adverse action in their records, impacting your ability to open up another account. The payday lender will attempt to collect on the loan. However, if the loan is in default, the lender can send the debt to a collection agency. A collection agency can report the default to the credit bureaus, impacting your credit score. A payday lender may also take you to court to collect the loan balance. A judgment will also appear on your credit report.
Defaulting on a loan will drastically reduce your credit score since payment history makes up 35% of your score. The lender or the debt collection agency will report the loan default to the credit bureaus. The defaulted loan will remain on your credit report for seven years. This will make it more difficult to qualify for a mortgage, auto loan, or credit cards. Poor credit can also impact your ability to get a job, find a place to live, and qualify for insurance and utilities.
Defaulting on a loan is not a crime. No lender of any type of loan can have you arrested for failing to pay a loan. Defaulting on a loan can be a civil offense and you may be required to appear in court. If you ignore a civil court order, you can be arrested for contempt of court. It is important to not ignore court notices or it can lead to criminal proceedings.
A loan default will stay on your credit report for seven years. You can have it removed earlier if the information is not accurate. A debt collection account can remain on your credit report for seven years plus 180 days from the date of the delinquency or missed payment.
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By:David Chang, ChFC®, CLU®
Writer, Consultant
David S. Chang, ChFC®, CLU® is an award-winning entrepreneur, keynote speaker, author, and consultant. He has over two decades of experience in the wealth management space and has been featured in dozens of news, radio, and podcast programs nationwide. He currently works as Head of IoT for the West Region of a Fortune 200 company. He is a graduate of the United States Military Academy at West Point and currently a Lieutenant Colonel in the California Army National Guard. He is an East-West Graduate Degree Fellow and has an MBA from the UCLA Anderson School of Management.
Fact CheckedEric McWhinnie
Eric McWhinnie has been writing and editing digital content since 2010. He specializes in personal finance and investing. He also holds a bachelor’s degree in Finance.
