When you take out a loan for a car, home, or any other type of personal loan, you are promising the financial institution to pay back the money according to the terms of the loan. Sometimes, things don't always go as planned, and people may find themselves unable to make their payments on time. If this happens to you, you are at risk of defaulting on your loan. A loan is in default if the borrower stops making payments on the loan. Defaulting on a loan can damage your credit score, making it more difficult to qualify for loans or better rates in the future.
What is a loan default?
What does it mean to default on a loan? A borrower defaults on a loan when they stop making payments on their loan. For most loans this means the borrower hasn't made several consecutive payments, breaking the terms of the agreement. The point when a loan is considered to be in default depends on the type and terms of the loan.
Loan defaults can happen with any loan, such as a mortgage, auto loan, credit card, or personal loan. Lenders will consider the loan to be in default if the minimum required payment is not paid for a certain time period that is specified in the agreement. The time period is typically one to nine months, depending on the type of loan. So if a borrower fails to make their car payments for several months in a row, then they have defaulted on their loan.
What happens if you default?
When a loan is in default, most lenders will require the borrower to pay the entire loan amount and interest immediately. Depending on the type of loan, the lender may seize any secured collateral or you may be taken to court and have your wages garnished. If there is a lawsuit, any judgment against you may be public record.
Payment history makes up 35% of your credit score, so defaulting on a loan will have serious consequences. A loan default will remain on your credit report for up to seven years. This can impact your ability to get any future mortgages, auto loans, and credit cards. If you do qualify, your interest rate will likely be very high. A low credit score can also hurt your chances of getting insurance, utilities, or approval to rent an apartment. Many employers also conduct credit checks before hiring an employee.
On top of this, the lender or collection agencies will continue to call and request payment from borrowers who have defaulted on their loans. They will continue to pressure you until the debt is paid off or threaten to take legal action.
Defaulting on a secured loan
A secured loan is backed by collateral such as a car or house. Defaulting on a secured loan means the lender will seize the collateral to pay off the loan. If you default on an auto loan, the lender will repossess the car. In the case of a home, the lender will foreclose on it.
The financial institution would then try to sell the asset to recoup their losses. If the collateral is not enough to pay off the loan, the lender may try to collect the remaining balance from you. In the rare case that the collateral is worth more than the loan, the lender may give you the surplus. In any case, defaulting on a loan will damage your credit score.
The most common types of secured loans are:
- Mortgage
- Auto loan
- Secured personal loan
- Secured business loan
Defaulting on an unsecured loan
An unsecured loan is not backed by an asset but it is backed by the borrower. Lenders will attempt to collect the remaining loan payments. If they are unable to do so, they typically send your loan to a collection department. In some cases, they may sue and attempt to garnish wages or put a lien on any property you may have.
The most common types of unsecured loans are:
- Credit cards
- Unsecured personal loan
- Unsecured business loan
What is the difference between default and delinquency?
A loan is delinquent if you have missed a payment but have not defaulted on the loan yet. Delinquency begins the first day after the due date. The loan then becomes delinquent or past due. The period of delinquency can last one to six months, depending on the loan terms.
Borrowers will usually be charged a penalty fee and the lender will contact the borrower to collect the payment. If the borrower makes the payment then the loan will be considered in good standing. If the lender has been unable to collect the loan payment while it is delinquent, then the loan will be considered in default.
Lenders will usually contact the credit bureaus to report a loan that is delinquent. The lender will send notifications to the borrower to let them know the loan is delinquent. If the lender is unable to do so, it will sell the debt to a collection agency and the collection agency will send notifications about the loan.
What is a grace period?
Some lenders will give a grace period if a payment is late. A grace period gives the borrower a short time period to repay the loan after the due date. There are no penalties incurred during this period. The loan however, will continue to accrue interest. Here are the typical grace periods for the different loan types. Keep in mind that the grace period varies based on the terms of your loan and yours may be different.