What Is a Default?

Default is the failure to repay a debt, including interest or principal, on a loan or security. A default can occur when a borrower is unable to make timely payments, misses payments, or avoids or stops making payments. Individuals, businesses, and even countries can default if they cannot keep up their debt obligations. Default risks are often calculated well in advance by creditors.

Key Takeaways

  • A default occurs when a borrower is unable to make timely payments, misses payments, or avoids or stops making payments on interest or principal owed.
  • Defaults can occur on secured debt, such as a mortgage loan secured by a house, or unsecured debt such as credit cards or a student loan.
  • Defaults can have consequences, such as lowering credit scores, reducing the chance of obtaining credit in the future, and raising interest rates on existing debt as well as any new obligations.
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Default

Default Explained

A default can occur on secured debt, such as a mortgage loan secured by a house or a business loan secured by a company's assets. If you fail to make timely mortgage payments, the loan could go into default. Similarly, if a business issues bonds—essentially borrowing from investors—and it's unable to make coupon payments to its bondholders, the business is in default on its bonds.

Defaults can also occur on unsecured debt such as credit card debt. A default has adverse effects on the borrower's credit and ability to borrow in the future.

Defaulting on Secured Debt vs. Unsecured Debt

When an individual, a business, or a nation defaults on a debt obligation, the lender or investor has some recourse to reclaim the funds due to them. However, this recourse varies based on whether the debt is secured or unsecured.

Secured debt

If a borrower defaults on a mortgage, the bank can reclaim the home that secures the mortgage. Also, if a borrower defaults on an auto loan, the lender can repossess the automobile. These are examples of secured loans. With a secured loan, the lender has a legal claim on the asset to satisfy the loan.

Corporations that are in default or close to default usually file for bankruptcy protection to avoid an all-out default on their debt obligations. However, if a business goes into bankruptcy, it effectively defaults on all of its loans and bonds since the original amounts of the debt are seldom paid back in full. Creditors with loans secured by the company's assets, such as buildings, inventory, or vehicles, may reclaim those assets in lieu of repayment. If there are any funds left over, the company's bondholders receive a stake in them, and shareholders are next in line. During corporate bankruptcies, sometimes a settlement can be reached between borrowers and lenders where only a portion of the debt is repaid.

Unsecured debt

A default can also occur on unsecured debt, such as medical bills and credit card debts. With unsecured debt, no assets are securing the debt, but the lender still has legal recourse in the event of default. Credit card companies often wait a few months before an account goes into default. However, if after six months or more there have been no payments, the account would get charged off—meaning the lender would take a loss on the account. The bank would likely sell the charged-off account to a collection agency and the borrower would need to repay the agency.

When a default involves unsecured debt, if no payments are made to the collection agency, a legal action might be taken in the form of a lien or judgment placed on the borrower's assets. A judgment lien is a court ruling that gives creditors the right to take possession of someone's property if they fail to fulfill their contractual obligations.

Defaulting on a Student Loan

Student loans are another type of unsecured debt. If you fail to pay your loan, you probably won't find a team of armed U.S. Marshals at your front door, as one Texas man did in 2016, as reported by CNN Money. But it’s still a very bad idea to ignore that debt.

In most respects, defaulting on a student loan has the same consequences as failing to pay off a credit card. However, in one key respect, it can be much worse. The federal government guarantees most student loans, and debt collectors dream of having the powers the Feds employ. It probably won’t be as bad as armed marshals at your door, but it could get very unpleasant.

First, you’re ‘delinquent’

When your loan payment is 90 days overdue, it is officially delinquent. That fact is reported to all three major credit bureaus. Your credit rating will be hit. That means that any new applications for credit may be denied, or given only at the higher interest rates available to risky borrowers. 

A bad credit rating can follow you in other ways. Potential employers, especially for any employee needing a security clearance, often check the credit score of applicants and consider it a measure of your character. So do most cellphone and cable internet service providers, who may deny you the service contract you want. Utility companies may demand a security deposit from customers they don’t consider creditworthy. A prospective landlord might reject your apartment application, as well.

Next, you’re ‘in default’

When your payment is 270 days late, it is officially in default. The financial institution you owe the money to will refer the problem to a collection agency. The agency will do its best to make you pay up, short of actions that are prohibited by the Fair Debt Collection Practices Act (FDCPA). Debt collectors also may tack on fees to cover the cost of collecting the money.

It may be years down the road before the federal government gets involved, but when it does, its powers are considerable. It can seize any tax refund you may receive and apply it to your outstanding debt. It can also garnish your paycheck, meaning it will contact your employer and arrange for a portion of your salary to be sent directly to repay the loan.

Alternatives to default

A good first step is to contact your lender as soon as you realize that you may have trouble keeping up your payments. The lender may be able to work with you on a more attainable repayment plan or steer you toward one of the federal programs. It is important to remember that none of the programs are available to people whose student loans have gone into default.

You may be sure the banks and the government are as anxious to get the money as you are about repaying it. Just make sure you alert them as soon as you see potential trouble ahead. Ignoring the problem will only make it worse.

If your federal student loans are already in default, you can enter the federal student loan rehabilitation program or you can use loan consolidation.

Sovereign Default

Sovereign default or national default occurs when a country cannot repay its debts. Government bonds are issued by governments to raise money to finance projects or day-to-day operations. Government bonds are typically considered low-risk investments since the government backs them. However, the debt issued by a government is only as safe as the government's finances and ability to back it.

If a country defaults on its sovereign debt or bonds, the ramifications can be severe and lead to a collapse of the country's financial markets. The economy might go into recession, or its currency might devalue. For countries, a default could mean not being able to raise funds needed for basic needs such as food, the police, or the military.

Sovereign default, like other types of default, can occur for a variety of reasons. In 2015, for example, Greece defaulted on a $1.73 billion payment to the International Monetary Fund (IMF) due to government overspending and a slowdown in global economic growth, sending shockwaves through the European Union.

Defaulting on a Futures Contract

Defaulting on a futures contract occurs when one party does not fulfill the obligations set forth by the agreement. Defaulting here usually involves the failure to settle the contract by the required date. A futures contract is a legal agreement for a transaction on a particular commodity or asset. One party to the contract agrees to buy at a specific date and price while the other party agrees to sell at the contract specified milestones.

What Happens When You Default on a Loan?

When a borrower defaults on a loan, the consequences can include:

  • Negative remarks on a borrower's credit report and lowering of their credit score, which is a numerical value or measure of a borrower's creditworthiness
  • Reduced chances of obtaining credit in the future
  • Higher interest rates on existing debt as well as any new debt
  • Garnishment of wages and other penalties. Garnishment refers to a legal process that instructs a third party to deduct payments directly from a borrower’s wages or bank account. 

A default will stay on your credit reports and be factored into your credit scores for seven years, according to credit bureau Experian.

Consequences of Bonds Defaulting

When bond issuers default on bonds or exhibit other signs of poor credit management, rating agencies lower their credit ratings. Bond credit-rating agencies measure the creditworthiness of corporate and government bonds to provide investors with an overview of the risks involved in investing in bonds.

A company's credit rating and ultimately the bond's credit rating impacts the interest rate that investors will receive. A lower rating might also prevent a company from issuing new bonds and raising the money needed to fund business operations.

Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s (S&P), for instance, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB is considered to be a speculative grade or a junk bond, which means it is more likely to default on loans.

Real World Example of a Default

Puerto Rico defaulted in 2015, when it paid only $628,000 toward a $58 million bond payment. After Hurricane Maria hit the island in late 2017, the country’s debt of more than $100 billion increasingly became a concern.

In 2019, Puerto Rico announced plans to reduce its debt to roughly $86 billion from $129 billion, through the largest bankruptcy in U.S. history. The move was made possible by a 2016 law passed by Congress, called Promesa, that essentially allows a U.S. territory to seek protection in bankruptcy court.