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Defaulting on a loan essentially means you've stopped making payments on a loan or credit card according to the account's terms. In general, defaulting on a loan can damage your credit and threaten your overall financial health.
What Happens When You Default on a Loan?
The terms and consequences of a default depend on the type of loan you have. Here's what to expect based on the type of debt.
Secured Loans
Secured loans and credit cards are backed by some form of collateral. If you default, the lender will typically use the collateral to pay off the remaining balance. Here's what that looks like for different types of secured loans:
- Mortgage loan: If you stop making payments on your mortgage, your lender can foreclose on your home and sell it to recoup its losses.
- Car loan: If you can't pay what you owe on a vehicle loan, the lender will usually repossess the car and sell it at auction to get what it's owed.
- Secured credit card: Secured credit cards are backed by a deposit you must make to receive the card. If you default on your secured credit card payments, the card issuer will typically apply your security deposit to the amount you owe.
- Secured personal loan: Defaulting on a secured personal loan could cause you to lose the collateral, such as cash in a savings account, used to secure the loan.
In all cases, if the lender doesn't get enough money from your collateral to pay off your debt in full, it may try to get the deficient amount directly from you. That can include suing you for the amount, which can result in a court order to garnish your wages, a lien on your property and more.
In some cases, such as with a car loan or secured credit card, the lender may end up with some money left over after using your collateral to pay off your balance. If this happens, the lender may return the surplus to you.
Unsecured Loans
With secured loans, a lender's recourse is pretty straightforward because you pledged collateral when you first applied for the loan, which it could tap if you default.
With unsecured loans, however, it can get more complicated. Here's what to expect from different unsecured loan types:
- Personal loan: If you stop making payments on a personal loan, the lender will typically send your account to its in-house collection department or sell it to a collection agency. If that doesn't work, the lender or collection agency may sue you to seek a court order for repayment, which can include wage garnishment or a lien on your property.
- Credit card: Credit cards are similar to personal loans in how lenders may attempt to collect on your unpaid debt.
- Student loan: The default process for student loans can vary depending on whether your loans are federal or private. Private loans will typically go through the same process as personal loans and credit cards. With federal loans, your loans will go to a collection agency, but there is an option to rehabilitate them through the U.S. Department of Education.
Again, it's important to note that the timing of default can vary by loan type, as well as by lender. For example, federal student loan default occurs after nine months of nonpayment, while a private student loan company may consider you to be in default if your payment is late for as little as 30 days.
What Is the Difference Between Default and Delinquency?
If you're behind on your payments, loan delinquency and default are two consequences you'll face.
Delinquency begins the moment you've missed a payment. You'll typically be charged a late fee, and your lender will begin to make collection attempts. You may be considered delinquent for anywhere between 30 and 90 days—and sometimes longer—before the lender considers you to be in default.
When the lender determines you are in default, typically collection attempts begin in earnest, either through the lender's own collection department or a third-party agency.
How Does a Defaulted Loan Affect Credit?
Defaulting on a loan can not only have serious immediate financial repercussions but also some long-term consequences.
When you're delinquent on a loan or credit card for at least 30 days, that late payment will be reported to the credit bureaus and will remain on your credit report for seven years. Once you default, that can also be reported to the credit reporting agencies as a collection account, which can further damage your credit score. Collection accounts also typically remain on your credit report for seven years.
With a default on your credit report, it can be challenging to get approved for credit in the future. That's because a lender's primary concern is repayment, and if your credit report indicates that you've failed to do that in the past, the lender may consider you to be too much of a risk.
But that doesn't necessarily mean that you won't ever qualify for another loan. Some lenders specialize in working with borrowers with negative credit issues, and they may offer a loan or credit card at a higher interest rate.
Also, it's important to keep in mind that credit scoring models typically favor new information over old information. So if you can manage to establish a positive payment history going forward, the effects of your default can diminish over time.
How to Avoid Defaulting on a Loan
Because defaulting on a loan can have long-term ramifications, it's best to try to do whatever you can to avoid it in the first place. Here are some tips that can help:
- Talk with your lender. Default isn't just expensive for you, it's expensive for lenders too. That's why many are willing to work with struggling borrowers to help them avoid default. If you're delinquent or worried about missing an upcoming payment, talk with your lender to try to come up with a modified payment plan.
- Ask about deferment options. With some loan types, particularly student loans, you may be able to request deferment or forbearance on your loan payments if you're experiencing financial hardship. Deferment and forbearance can give you some reprieve from your monthly payments for a time while you work to get back on your feet financially.
- Consider debt consolidation. If your credit score is in decent shape, you may be able to consolidate your debt with a new loan, which will pay off the original debt and ideally neutralize the threat of default. This option is best considered if you are having difficulty keeping up with several debt payments and have a plan to pay off the new loan. If not, you could just be delaying the inevitable.
As you consider these and other ways to avoid default, you may be able to prevent further damage to your credit.
Keep an Eye on Your Credit Score if You're Struggling With Payments
Checking your credit score won't stop a delinquent or defaulted account from affecting it, but it's important to understand how different actions influence your score. Monitoring your credit can also help you stay motivated to make monthly payments and avoid allowing a delinquency or default to happen in the first place.
