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Defaulting on a loan happens when repayments aren't made for a certain period of time. When a loan defaults, it is sent to a debt collection agency whose job is to contact the borrower and receive the unpaid funds. Defaulting will drastically reduce your credit score, impact your ability to receive future credit, and can lead to the seizure of personal property. If you can't make payments on time, it's important to contact your lender or loan servicer to discuss restructuring your loan terms.
- What is a Defaulted Loan?
- What Happens When You Default?
- How Do You Get Out of Default?
Loan Default Explained
Loan default occurs when a borrower fails to pay back a debt according to the initial arrangement. In the case of most consumer loans, this means that successive payments have been missed over the course of weeks or months. Fortunately, lenders and loan servicers usually allow a grace period before penalizing the borrower after missing one payment. The period between missing a loan payment and having the loan default is known as delinquency. The delinquency period gives the debtor time to avoid default by contacting their loan servicer or making up missed payments.
How long until default after last payment?
|Student Loan||270 days||90 days to make a payment|
|Mortgage||30 days||15 days to make a payment|
|Credit Card||180 days||1 missed payment allowed before penalty|
|Auto Loan||1 to 30 days||Varies widely|
The consequences of defaulting on a loan of any type are severe and should be avoided at all costs. If you miss a payment or your loan is in delinquency for a few months, the best thing to do is to contact the company who manages your loan. Often times, loan servicers will work with debtors to create a payment plan that works for both parties. Otherwise, leaving a loan in delinquency and allowing it to default can, in the worst cases, lead to seizure of assets or wages.
How Loan Default Works
Defaulting on a loan will cause a substantial and lasting drop in the debtor's credit score, as well as extremely high interest rates on any future loan. For loans secured with collateral, defaulting will likely result in the pledged asset being seized by the bank. The most popular types of consumer loans that are backed by collateral are mortgages, auto loans and secured personal loans. For unsecured debts like credit cards and student loans, the consequences of default vary in severity according to the type of loan. In the most extreme cases, debt collection agencies can garnish wages to pay back the outstanding debt.
What Can Happen After Default?
|Student Loan||Wage garnishment|
|Credit Card||Possible lawsuit and wage garnishment|
|Auto Loan||Car repossession|
|Secured Personal or Business Loan||Asset seizure|
|Unsecured Personal or Business Loan||Lawsuit and revenue or wage garnishment|
For federal student loans, the first consequence of default is that "acceleration" kicks in, meaning that the entire loan balance is due immediately. If this balance doesn't get paid off, the government can then withhold tax refunds or any federal benefits that the borrower receives. Debt collectors can also sue borrowers to win the right to seize their wages—and after such a trial, debtors are often charged with the collector's court fees.
As with other debt obligations, defaulting on a student loan will send a borrower's credit score plummeting, from which it can take years to recover. Unlike other loans, student loan defaults stay on a borrower's record for life, even if bankruptcy is filed. Additionally, borrowers who default become ineligible to take out any more federal student aid or to apply for loan deferment or forbearance, which can help struggling debtors.
The good news is that student loans have a long delinquency period before they default—270 days, or roughly nine months. This allows proactive borrowers to get their finances straight and avoiding defaulting altogether. For borrowers with a delinquent loan, remember that it's most important to stay in contact with your loan servicer and communicate your financial situation to them, especially if you feel that you can't make your loan payments.
While most credit card companies allow one late payment before penalizing card holders, missing multiple bills can ding a credit score by as much as 125 points. Additionally, card companies can add a late fee of $35 to $40, as well as apply a penalty interest rate—which will make the cost of the outstanding debt much higher. Once a credit card debt defaults, it will trigger an aggressive debt collection process, during which borrowers are contacted frequently by collection agencies. However, while it is possible for collectors to sue and win a wage garnishment, it's more likely that they'll be willing to negotiate a partial debt repayment.
The typical delinquency period before a credit card debt defaults is around 6 months. While this period gives debtors a sufficient amount of time to straighten out their finances, it can also be a time when the debt, if left unpaid, rapidly accrues interest. For debtors looking to avoid this situation, a good option is to take out a personal loan to consolidate your outstanding debt. These types of personal loans allow for fixed monthly payments and generally have lower interest rates than credit cards.
Mortgages are secured with the purchased home as collateral, meaning that the home can be seized if the loan isn't paid back according to the initial agreement. For most homeowners, this means that defaulting on a mortgage will lead to foreclosure. While this is a drastic consequence, foreclosure can be avoided by figuring out how to refinance your mortgage to make it more affordable. Eligible homeowners might consider the Home Affordable Refinance program, or HARP, which is designed to help underwater borrowers.
Above all, making your payments on time can help you avoid default. Like with other loans, it's important to communicate with your loan servicer if you think you can't make your mortgage payment. If you've made payments on time in the past and can prove your current financial distress, you may be able to negotiate for a restructured loan agreement.
When an auto loan defaults, the lender or car dealer is usually able to seize or repossess the car to pay for the outstanding debt. However, repossession is a last resort move for most auto lenders. Because the value of a car depreciates over time, it's likely that the current value of a repossessed car isn't enough to cover the outstanding balance of a defaulted loan. Repossessed cars also have to be resold for the lender to get any cash—and as such, lenders prefer to get money directly from their borrower rather than seize collateral. So most of the time, they're willing to work with borrowers to restructure the terms of an auto loan.
Other Types of Loans
For personal loans and business loans, the consequences of default vary depending on whether the loan is secured or unsecured. With business loans, defaulting can often times have a negative impact on the business owner's credit score if the loan was backed by a personal guarantee. Defaulting on a personal loan will also make it much harder to receive credit in the future. However, as outlined in the sections above, these defaults can be avoided by proactively communicating with your lender to negotiate for a restructured loan.
- For secured personal loans, default will usually result in the collateral asset being seized by the lender
- For secured business loans, default will usually result in lenders seizing revenue or inventory
- For unsecured personal loans, default will often result in wage garnishment
- For unsecured business loans, lenders can litigate to receive a lien against a company's earnings
How to Get Out of Loan Default
For student loans, there are specific programs like loan consolidation and loan rehabilitation that are designed to get student loan debtors out of default. Rehabilitating a student loan allows borrowers to make a monthly payment that is equal to 15% of their monthly income. To qualify, borrowers must first make nine consecutive payments. Loan consolidation, the other federal program, allows a borrower to get out of default by making three consecutive monthly payments at the full initial price, and afterwards enrolling into an income-driven repayment plan. Because student loans are not wiped out by declaring bankruptcy, these programs exist as a way for lenders to recoup their losses.
For other types of loans, it's much harder to find specific programs or loans designed to help debtors get out of default. Your best bet is to negotiate a repayment plan with your debt collector if it's possible. On the other hand, depending on the size of your defaulted loan and the severity of your debt, you may want to hire a bankruptcy lawyer to examine your financial situation. If you're far too overwhelmed with outstanding debt obligations, it's likely that you could benefit from the loan forgiveness provided by declaring bankruptcy.