What happens in the event of default on a loan?
You can take out a loan with the intention of paying it back, but the unexpected happens and you default, not paying off your debt. Defaulting on a loan can happen even to responsible borrowers.
Job loss, lost wages and other emergencies can lead to defaults, as can unforeseen outside factors like the coronavirus pandemic. The COVID-19 crisis has caused financial hardship and many homeowners have not been able to make their mortgage payments. In fact, the mortgage default rate in the United States reached 8.2% at the end of June 2020, the highest since 2011, although it has since fallen to 5.47% in the second quarter of 2021, according to Mortgage. Bankers Association.
So, what is a default on a loan? First, your loan is in arrears when you are in arrears. When you stop paying for a certain period of time, your loan will default.
Borrowers who fail to repay their loans not only damage their credit, but also risk lawsuits and payday foreclosures. Here’s what you need to know about default and how you can avoid it.
What does it mean to default on a loan?
A default occurs when a borrower breaks their original agreement with a creditor or lender by interrupting their payments.
“Defaulting on a loan means the borrower has not delayed ending the agreement with the creditor,” says Leslie H. Tayne, debt settlement lawyer and founder of Tayne Law Group in New York .
But what does defaulting on a loan mean to creditors? What triggers a default varies depending on the type of loan and the lender, she says.
Many, but not all, creditors assume that if around 180 days go by without you having to pay, you don’t intend to pay, says Tayne. A default can arise at this stage, but loan deadlines differ. Here is what is typical for the main types of loans:
If you are responsible for a loan, you need to know your default deadline so that you can take steps to avoid it. Check the terms and conditions of your loan or ask your lender to clarify them.
What happens in the event of default on a loan?
Defaulting, which signals a long-term default, can hurt your credit score, Tayne says. The main factor that influences both your FICO score and VantageScore is your payment history.
“It’s likely that your scores will drop as soon as you’re flagged overdue, which can happen 30 days after your due date,” says credit expert John Ulzheimer, formerly of Equifax and FICO.
A default value results in a decrease in the score for the next few years. “So as long as you got a good score but then suffered and ended up defaulting, the impact could be significant,” he says.
A default stays on your credit report for up to seven years, which can make it difficult to qualify for mortgages and auto loans, Tayne adds.
Any time your credit is checked, a fragmented payment history can come back to haunt you.
“A default can have an impact on costs, rates and the availability of (credit),” says Tayne. “In addition, other creditors may close or reduce credit due to default.”
You could face more serious fallout than just the effect on your credit score:
- For federal student loans. Your wages can be garnished and tax refunds withheld.
- For private student loans. You could be sued.
- For mortgages. The lender can foreclose on the house and take control of the property.
- For auto loans. The car can be taken back and sold at auction, with any remaining debt payable by you.
- For credit cards and personal loans. For unsecured debts, you can be sued, which could force repayment through wage garnishment, or a lien can be placed on your property.
“When your loan is in default, you will likely start receiving collection calls, either from the original creditor or from a third-party collection agency to which the creditor sold or transferred your debt,” Tayne said.
Ignoring payment requests doesn’t make them go away. Debt collectors will simply find new ways to pressure you to pay, which can include lawsuits, she says.
A lawsuit can result in a public record and judgment against you. This means that the creditor can then take more severe measures to collect the debt, such as garnishing the salary or the bank account.
“A default judgment is more likely if you ignore the lawsuit or don’t respond in a timely manner,” Tayne says. “A judgment can occur even if you answer or respond to the lawsuit but have no valid legal defense other than the inability to pay.”
Why can a payment default occur?
Some borrowers intentionally decide not to pay, but default is often caused by circumstances beyond your control. “A loan can be in default because the borrower is simply unable to make payments for an extended period and is aware of missing payments,” says Tayne.
Job loss, illness and natural disasters are common reasons for non-repayment. Sometimes a borrower may forget to make payments, mistakenly believing the loan was self-paying.
Still, defaulting on a loan isn’t exactly easy, says Ulzheimer.
“Every time you take out a loan, you sign a promissory note that requires you to repay your debt on certain conditions,” he explains. “I see too many people treating this note like it’s a suggestion rather than hard and fast rules.”
Ultimately, defaulting on a loan means you’re ignoring your obligations, he says.
How to avoid a payment default?
If you can’t pay off your loan, talk to your lender first – ideally before you miss your due date. Your lender may enroll you in a deferment or forbearance program or offer you a loan modification.
Some lenders still offer special programs for borrowers experiencing financial hardship due to COVID-19. Banks may allow you to skip a loan payment if you make arrangements, and many student loan borrowers may be eligible for coronavirus relief. But skipping a payment on your mortgage or other loan is not ideal and should be reserved when the alternative is default.
Either of these options can immediately relieve financial pressure and give you the ability to pay off your loan without default. Other choices can help you manage a loan that’s close to default, including:
- Debt consolidation. When you consolidate, you consolidate all of your debt balances into a new loan and your old creditors are paid off. It can save you time and simplify your debt in one payment.
- Refinancing. If you think you might qualify for a lower interest rate, refinancing can help lower your monthly payment. Typically, the loan term will be extended so that your payments are more spread out, but you will pay more over the life of the loan.
- Opening a balance transfer credit card with an introductory annual percentage rate of 0%. If you are able to transfer high interest debt to a 0% interest card for a specified period of time, it can help you progress further in paying off principal. While there is usually a balance transfer fee, if you can pay off most or all of the debt before the introductory rate expires, you will get debt relief and come out the winner.
One caveat is that you may need a good to excellent credit rating to qualify for all of these opportunities. These options may be out of reach if you have defaulted or have credit problems.
Also note: “Consolidation doesn’t reduce the amount you owe, but it could potentially lower your interest rate and simplify your monthly bills,” says Tayne.
What should you do if you defaulted on a loan?
Once you’ve failed, controlling the damage is key. Follow these steps to get your credit back on track:
- Pay your overdue amount. Updating your account may stop the bleeding. If you can get and stay up to date, you will no longer add derogatory ratings to your credit and stop accumulating penalty fees.
- Talk to your creditor about debt relief programs. You may need to sign up for deferral or forbearance or restructure your payment plan to stay current.
- Monitor your credit. Once you’re on the right track, check your credit to make sure your account is reported as up to date.
Whatever you do, don’t ignore your debt. You can speak to a financial professional, such as a debt attorney, for advice or contact your loan officer for options if you know you’re going to have difficulty paying.
Remember, your lender can also help you make a loan repayment plan. It can help you better manage the burden of debt on your mental and physical health and on your relationships.
“Ignoring your loan and letting it default can have disastrous long-term effects, including increasing balances, causing lawsuits, damaging your credit, or losing secured items like a car or house,” says Tayne.