What Is the Difference Between Default and Bankruptcy?

What Is the Difference Between Default and Bankruptcy? article image.

Defaulting on an account and filing bankruptcy both can hurt your credit, but they're far from the same thing. Defaulting is when a borrower falls behind on payments. Bankruptcy is a legal process that you can use to get your debts discharged or get on a more manageable repayment plan.

What Does It Mean to Default on a Credit Account?

When you take out a loan or open a credit card, you agree to a contract that outlines your payment amount as well as how and when you need to make your payments. If you don't follow the agreement and neglect to pay, your account can go into default.

Generally, a missed payment will initially lead to being delinquent and your account won't go into default until you've been delinquent for several months. However, the number of payments you'll need to miss before defaulting can depend on the type of loan, lender and your agreement.

For example, direct federal student loans default once you're 270 days past due, but Federal Perkins Loan (which are no longer available to new borrowers) can default if you're one day late.

Defaulting on a credit account can have various repercussions. With installment loans, you may get kicked off your monthly payment plan and owe the entire amount immediately. If you have a secured loan, such as an auto loan backed by a vehicle, the creditor may repossess the car used to back it up. And if you're 60 or more days late with a credit card, the issuer may apply a penalty annual percentage rate (APR) to your current and future balances.

There also may be penalties for being one day late. Even if the creditor considers this delinquent rather than in default it may charge you a late payment fee or take away promotional interest rates, such as a promotional 0% APR on purchases. Some creditors, however, also give you a grace period and there won't be any consequences if you bring your account current during the grace period.

Once you're 30 or more days late, the creditors can also report your late payments to the credit bureaus. The late payments can hurt your credit and will stay on your credit report for seven years.

How Does Bankruptcy Work?

Borrowers who are overwhelmed by debt and unable to catch up on payments may decide to file a Chapter 7 or Chapter 13 bankruptcy. (There are other types as well, but these are the most common options for consumers.) The bankruptcy procedure and the consequences it will have depends on the type of bankruptcy you undergo.

A Chapter 7 bankruptcy (also called a liquidation bankruptcy) can discharge many types of unsecured loans. These could include credit card balances, medical bills and unsecured personal loans, but student loans generally can't be wiped away through bankruptcy.

During the process, a court-appointed trustee can sell off your possessions and use the money to pay your creditors. There are exemptions that may allow you to keep some retirement savings and certain possessions (depending on their value).

A Chapter 13 bankruptcy (or reorganization bankruptcy) lets you keep your property while you commit to a new payment plan with your creditors. Generally, the payment plan lasts three to five years and any remaining debts will be discharged once you complete the plan.

But you'll need to have enough income to afford the payment plan. With a Chapter 13 bankruptcy, there are limits on how much debt you can have—currently, about $400,000 in unsecured debt and $1.1 million in secured debt.

Regardless of which one you pursue, Chapter 7 and Chapter 13 bankruptcy will have major consequences. Your credit scores can take a significant hit, and you may find creditors unwilling to approve your applications for new accounts if you've declared bankruptcy in recent years. The bankruptcy record will stay on your credit reports for up to 10 years (for a Chapter 7) or seven years (for a completed Chapter 13) and continue to impact your credit during that time.

Other Options for Dealing With Debt

If you're having trouble paying all your bills, you may find yourself prioritizing which payments to make as scheduled and which to let go past due. You may have even researched how to file for bankruptcy. But don't overlook your other options.

First, contact your creditors. Some companies offer hardship plans that could lower your monthly payment, temporarily decrease your interest rate or let you pause your payments. Also look into different types of debt consolidation programs, such as a debt consolidation loan or debt management plan. These can help decrease your monthly payment, which may allow you to stay current on your loans and avoid hurting your credit. Declaring bankruptcy will have a major negative effect on your credit, so carefully consider your options to hopefully avoid that outcome.