When you take a bank, credit card, or cash advance apps loan, you guarantee that you will pay back the money you have taken. If you fail to pay it back, that is when you default on a loan. Now that we know the loan default definition, we must know about the challenges we will face if we find ourselves in this situation.
A loan default can have a major impact on your credit score, and in extreme cases, the lender can sue you. In this article, we have answered your questions like what happens when you default on a loan? How to avoid defaulting on a loan? etc., so, let’s get started.
What Does Defaulting on a Loan Mean?
So, what does it mean to default on a loan? When a borrower stops making payments for the loan, based on an agreement that was agreed upon by the borrower and the lender, that is when the borrower defaults on a loan. The time frame of the repayments is decided according to the agreement; if you are not able to pay within these time frames, your loan can get overdue. After that, it becomes a loan default. The time frame ranges from 30 days to 270 days, depending on the nature of the loan.
Well, default on a loan is not unusual. According to the Department of Education, 11.5% of students who had taken federal student loans faced a loan default after two years. A Federal Reserve Bank of St. Louis report stated that 2.53% of bank credit cards have a defaulted account.
What Happens When You Default on a Loan?
When you default on debt, the lender will want the entire loan amount and the interest incurred. When you fail to pay back the money, the lender can seize your collateral if it was a secured loan or take the issue to court if it was an unsecured loan. Any proceedings in the court will be on public record, which can be a disturbing experience.
Defaulting on a loan can have a serious impact on your credit score. Loan default is present on your credit report for 7 years, which can hinder your chances of getting future loans or credit cards. Even if you get a personal loan for bad credit , it will have a high interest rate.
Having a low credit score will make it difficult to get approval for any car insurance or home loans as well. In addition to this, the loan agencies will keep calling you to request repayments. They will keep disturbing and threatening you until you pay back the loan.
Now, the consequences of a default on debt vary on the type of loan taken. Loans are of two types: secured loans and unsecured loans.
1. Secured Loans
Secured loans are loans where the borrower puts in collateral against the loan. If you do not succeed in paying back the loan, the lender confiscates the collateral to pay off the remaining balance. Here are some examples of secured loans:
When you stop making payments for your house loan, the lender can seize your house and sell it to compensate for the loan.
Secured Credit Card
You can get secured credit cards by paying hefty security deposit fees. If you don’t pay back the loan, banks compensate for it by taking away your security deposit and savings.
Secured Personal Loan
You can get a personal loan by keeping your savings as collateral. In case you are unable to repay and default on a loan, your savings will be confiscated by the respective bank. You can get loans for federal employees but in case of any delinquency your salary can be obstructed.
2. Unsecured Loans
For an unsecured loan, you do not need to put in collateral. This potentially makes them more dangerous if you default on a loan as the lender can take serious legal action against defaulters. Here are some examples of unsecured loans:
For example, you need 2000 dollars fast and take a loan for it. Afterward, you stop making payments for its repayment. Now, the bank will usually send your account information to a collection agency, to retrieve the money. If that does not work, the bank can sue you, resulting in wage garnishment and property confiscation.
When you miss payments for your student loan, what happens after can vary according to the loan type. For private student loans, the default process is similar to personal loans. In the case of federal student loans, when you default, your account information will be sent to a collection agency, but there is a way to recover from this, with the help of the American Department of Education.
Steps to Follow if You Default on a Loan
Now that we know what does it mean to default on a loan and what happens when you default on various kinds of loans, let’s see what to do next. When you first realize that you will not be able to repay your loan within the specified time frame, it is best to inform your lender as soon as possible, and make him empathize with your situation. There is a chance that the lender will extend the time frame. If you default on a federal student loan, you can recover from it with the help of the U.S. Department of Education.
In terms of mortgage loans or car loans, banks come up with repayment structures based on your income that you can follow to avoid default on a debt. If you still are not able to pay back the loan there are some extreme measures that you can take, such as, declaring bankruptcy or joining a loan consolidation program to recover from this situation. Before taking these measures it is recommended to talk to your lawyers.
How to Effectively Avoid Defaulting on a Loan?
It is a common mistake to forget payment dates and miss repayments, which lead to defaulting on a loan. To avoid this, enable the auto-pay feature in your account, which automatically completes the loan repayment from your income. If the problem is much more severe, and you are unable to pay your loan repayments due to an ongoing financial crisis, the best option is to contact your lender and come clean about your situation.
The lender can extend the time frame of the loan. So, there are two programs that the lender can recommend, the forbearance program or the deferment program. Through the Forbearance program, the lender delays your loan payment deadline, but the interest rates keep accumulating. In contrast, through the deferment program, your loan deadline is delayed without interest rates being charged.
Other than these options, there are debt consolidation programs, where a credit counselor creates a structure for refinancing your present loans or removing your debt to a low-interest account. Lastly, it is all about honest communication with your lender, so, they do not report any delinquencies that affect your credit score.
How Does Default on a Loan Affect Your Credit Score?
Around 35% of your credit score depends on payment history. So, a loan default can have a major impact on your credit score. When you default on debt, the report is present on your credit report for 7 years. Your late payments may be reported to collection agencies, which can impact your credit score as well.
A report made by the collection agency is also present on your credit report for 7 years. A loan default with major loan default consequences such as a bad credit score, can obstruct your chances of getting financial assistance in the future.
Even if you get a personal loan for bad credit it will have a high-interest rate. Having a low credit score will also make it difficult to get approval for car insurance, home loans, etc.
However, credit bureaus prefer new financial information over old. So, if you start building your credit and pay your bills on time, your bad credit history from default on a loan is sure to become irrelevant over time.
Delinquency Vs Default
Delinquency occurs when you miss the first due date of repaying your loan. A delinquent loan is the stage prior to the stage of defaulting on a loan. A loan is considered delinquent for a period ranging from 1 to 6 months, depending upon the loan.
For a delinquent loan, your lender can charge a penalty fee. If you are unable to pay the fine, it will be considered a default on a loan. If you pay the late fee and make the repayment, the loan is considered in good standing.
Lenders report delinquencies to credit bureaus, that is why it affects your credit score. Then, what does it mean to default on a loan? A default on a loan means when you are failing to repay the loan within the agreed time frame. If you are unable to pay for more than 6 months, your loan is considered a default on debt.
Q1. Is defaulting on a loan a crime?
Loan default is considered a civil charge and not punished as per criminal offense. This means if you are a genuine defaulter you can resolve your issue with your lender and recover.
Q2. Can loans in default be forgiven?
Depending on the type of loan any defaults in a private student loan are not forgiven whereas, in a federal student loan the student gets a chance to recover from the U.S. Department of Education.
Q3. How long does a loan default stay on record?
A loan default, delinquency, or bankruptcy stays on a credit report for 7 long years.
I hope this article clears your confusion regarding the aftermath of defaulting a loan. As you have read, a loan default can have a bad impact on your credit score, which can hinder your chances of maintaining good credit. Even if you get a personal loan for bad credit it will have a high-interest rate. Finally, a loan default is not a permanent mark on your credit report, you can reduce it to the point of disabling your bad credit history, by making timely payments and building your credit sincerely and responsibly.