A default is when a borrower doesn’t repay a loan according to the terms agreed on with a lender. This can happen to individuals, businesses, and even governments.
Learn the possible consequences of a default and how you might avoid them below.
When is a loan considered in default?
A loan is considered in default when the borrower misses payments for a long period or breaks the terms of the loan agreement.
Generally, this doesn’t happen after just 1 missed payment. Most lenders allow a grace period for overdue loan payments.
If the borrower still fails to pay after the grace period, the loan may be declared in default.
It’s important to check the fine print of a loan agreement before signing it to make sure you have the ability to borrow money responsibly.
Secured vs. unsecured debt
What will happen in case of a default? That may depend on whether the debt is secured or unsecured.
Secured loans are tied to property or assets, like home and car loans. These assets are referred to as Collateral. In the event of a default, the lender can take ownership of the asset that was used to secure the borrowed money.
On the other hand, unsecured debt, like personal loans, isn’t backed by property. If the borrower defaults, the lender can’t seize any asset directly but can seek other legal measures to recover the money.
What a default means for individuals
Unpaid debts can bring emotional and financial strain, especially when collectors come calling and interest and fees start to pile up.
Understanding the risks of nonpayment highlights the importance of acting early when financial trouble begins.
- Loss of property
If you default on a secured loan, the lender can reclaim the property that’s tied to the agreement then sell it to recover the unpaid amount. For example, a car can be repossessed and a house can be foreclosed.
- Legal action
Lenders may file collection suits for unsecured debt. If the court rules in favor of the lender, collection measures may be taken, such as the seizure of a borrower’s valuable possessions to pay off the debt.
A court can also order garnishment, which means a portion of a borrower’s salary or bank deposits will be remitted to the lender as repayment.
Take note that you can’t go to jail for not paying debts unless criminal acts like fraud/ estafa are involved.
- Dealing with collectors
Creditors may sell defaulted loans to collection agencies. These third-party collectors will then pursue payments from borrowers.
Their collection methods can include calls and demand letters, which could add to the stress of having unpaid debts.
As a borrower, you should know that there are guidelines from regulatory bodies aiming to protect you from overly aggressive or abusive collection practices.
- Poor credit standing
Defaulting on an obligation can damage your credit rating. A bad credit history can make it harder to get approved for future loans. The loans that are available to “risky” borrowers tend to have higher interest rates.
Aside from banks, potential employers and landlords may also look into your credit history. This can affect future searches for a new job, car or home.
What a default means for businesses
Big or small, businesses can also fail to repay the money they borrowed from banks and other creditors like bondholders.
A company may go bankrupt if its financial problems run deep. Like individual borrowers, its assets may be sold to repay creditors.
If you’d like to invest in corporate bonds, it’s important to check the issuing company’s creditworthiness to know whether a default is likely.
Default risk means there’s a possibility you won’t get interest payments and the money you invested in the company’s debt securities, like bonds. A company’s financial health can also affect the value of its stocks.
What a default means for governments
When a government defaults on its debt, it may lose trust from local and international creditors and investors.
The country will likely get a lower credit rating, which can make borrowing money for recovery and economic growth more expensive and challenging.
The national currency may also weaken and prompt the government to raise taxes to cover repayments. Such developments can then affect the cost of living and the performance of financial markets.
Like corporate bonds, a government’s bond issuances are also subject to default risk. However, governments tend to have a wider range of financial resources that it can use to prevent a default.
Avoiding a default as an individual borrower
Unexpected events can make it difficult to manage obligations even if you’re wise with money. However, you can still recover from debt and take control of your finances by being proactive. Here’s what you can do:
- Consider debt consolidation to simplify repayment.
- Learn about the snowball and avalanche methods of clearing debt.
- Work out a repayment plan with your lender.
Once your debt is manageable, you can keep working on your financial wellness by building an emergency fund for unexpected expenses.
This can serve as the foundation of better money management practices, which should later include saving and investing for your goals.
