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The Basics of Borrowing Money: What Happens When You Default On a Loan?

The Basics of Borrowing Money: What Happens When You Default On a Loan?

To understand what happens when you default on a loan, we first have to understand what defaulting on a loan means. “Defaulting” on a loan is a catch-all term that means the borrower has failed to adhere to the terms of the loan, and so in absence of the regularly scheduled payments, the lender will begin action to try and recoup their losses in other ways. The terms for each type of loan are different, although the process by which a borrower defaults on a loan is generally very similar. 

How It Starts: Missing Payments

Missing a payment (and thereby failing to adhere to the terms of the loan) is what kick starts the default process.  Some loans, mostly credit cards, allow for a missed payment, although most other loans have a small grace period built in, allowing the borrower to have a little extra time to make the payment (usually 10-20 days). After you have officially missed the scheduled payment, the clock starts ticking down until the loan officially defaults. Again the type of loan (student, home, auto, personal, business) determines how long it takes until the clock expires. Auto loans and home mortgages are the fastest to default, followed by credit cards and student loans.

Your Credit Score Starts Crashing

How the lender will start trying to recoup their losses after a loan becomes defaulted depends on the type of loan, so the consequences can vary greatly.  However, there is one universal consequence that comes with defaulting on any type of loan: your credit is going to take a serious hit. How hard your credit is hit will depend on how good your credit currently is. If your credit is in the 700’s then defaulting on a mortgage could lower your credit by 150 points.

Even missing multiple payments on a credit card can lower your credit by over 100 points. Defaulting on almost any type of loan sends a serious signal to credit bureaus that your ability/willingness to repay future loans is at risk. A foreclosure is kept on a person’s credit report for 7 years, during which you may suffer some of the consequence of bad credit.  For example, other loans that you apply for are less likely to be approved. It may also be harder to get approved for an apartment, or even harder finding a job.

You Could Lose Your Assets

One of the most obvious consequence of defaulting on a loan occurs when you default on a loan secured with collateral.  Sometimes the collateral is the very thing that you took out the loan for: auto and home loans are clear examples of this.  Sometimes collateral is something else that you offered up to the lender when you applied for the loan. In either case, once the loan goes into default, the lender uses your collateral to help recoup their losses. If you default on a car loan, the car is repossessed.  

If you default on a mortgage your home is foreclosed. If you offered up a tractor as collateral for a business loan, and you default on that loan, the tractor is sold off to try and recover the lender’s losses. This process can have devastating consequences, as you essentially lose all of the money you paid back on the loan so far, and you lose the collateral, possibly leaving you worse off than when you began. This is why debt consolidation is often encouraged, moving debt from secured loans into unsecured loans in order to reduce possible losses.    

Debt Collectors Will Begin Calling

The consequences of defaulting on unsecured loans are a lot less concrete, although they have the possibility to be even worse than their counterparts. After you default on a unsecured loan such as a personal loan or a credit card bill, the debt is moved to the collection department. This starts a debt collection process that is often very overwhelming for the debtor. Hundreds of aggressive calls from the collection department could come, with threats of legal action if the outstanding amount of the debt, plus late fees and interest, is not paid. Sometimes once defaulted, the debt can be sold off to a third party.

These third parties are companies whose entire business model revolves around purchasing debt, often for around four cents on the dollar, and then doing all they possibly can to get that money back from you. It is likely that the collection department/third party will seek to negotiate a partial repayment as recompense, but it is possible that a lawsuit could ensue. If a lawsuit does occur, it is likely that the judge could allow your wages to be garnished and force you to pay the legal fees of the lendor. If someone defaults on a personal business loan, the company’s earnings could be garnished.

Why You Shouldn’t Default on Student Loans     

Student loans are another beast entirely, largely due to the fact that the federal government is usually the lender. The delinquency period of student loans are typically the longest, usually around 270 days, allowing students as much time as possible to restructure payments before defaulting.  However if a default occurs, the immediate consequence is that you will lose access to a variety of protections. You won’t be able to restructure or choose a different payment plan option, or be eligible for any federal forgiveness program.

You Can’t Defer Student Loan Payments Once You Default

You won’t be able to defer any payments, and you will not be eligible for any new federal student loans until after you finish paying off your last loan completely, whether the full amount plus interest or through a negotiated partial repayment. The federal government has the power to apply your yearly tax refund to your outstanding debt, and to even begin garnishing your paycheck. Up to 15% of your total paycheck could be garnished to be used to pay all the interest, principle and collection fees incurred with your loan. Lastly, student loans are notoriously the most difficult to shed with bankruptcy, adding more to their different nature.  

Save Yourself the Stress – Avoid Defaulting on Debt

Defaulting on a loan can have very real consequences.  Lawsuits, damaged credit, and a lack of future financial flexibility are serious consequences. There are multiple ways you can avoid defaulting on a loan: seeing a debt counselor, consolidating debt, and restructuring a loan, to name a few.  Researching your options could take some time; however, it will be worth all the effort if you can avoid defaulting on your loan.


About Brittni Abiolu

Brittni AbioluBrittni has been an entrepreneur and investor for 10+ years. She writes about her experiences as a business owner and uses data and information from reliable sources to back up what she writes about. Through her writing she aims to educate other entrepreneurs on how to obtain capital and build successful businesses doing what they love.


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