Default: What It Means, What Happens When You Default, Examples

What Is a Default?

Default is the failure to make required interest or principal repayments on a debt, whether that debt is a loan or a security. Individuals, businesses, and even countries can default on their debt obligations. Default risk is an important consideration for creditors.

Understanding a Default

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 a borrower fails to make timely payments, the loan could go into default and the asset, or collateral, used to secure it would then be in jeopardy. Similarly, a company unable to make required coupon payments on its bonds would be in default.

Defaults can also occur on unsecured debt such as credit card balances. A default reduces the borrower's credit rating and may limit their ability to borrow in the future.

Defaulting on Secured Debt vs. Unsecured Debt

When an individual, a business, or country defaults on a debt, its lenders or investors may sue to recover the funds. Their recovery prospects will depend, in part, on whether the debt is secured or unsecured.

Secured Debt

If a borrower defaults on a mortgage, the bank may ultimately foreclose on the home that secures the mortgage. If a borrower defaults on an auto loan, the lender can repossess the vehicle. These are examples of secured loans. With a secured loan, the lender has a legal claim to a particular asset acquired with the loan.

Corporations in default on secured debt may file for bankruptcy protection to avoid forfeiture, providing time for negotiations on a settlement with creditors.

Unsecured Debt

A default can also occur on unsecured debt, such as medical bills and credit card balances. While unsecured debt is not backed by an asset, the lender still has a legal claim in the event of a default. Credit card companies often wait a few months before sending an account into default.

After six or more months without payments on an outstanding balance, the debt would get charged off, meaning the lender would write it off as a loss and close the account. The creditor may then sell the charged-off debt to a collection agency, which would then attempt to collect from the borrower.

Defaulting on a Student Loan

Student loans are another type of unsecured debt. Defaulting on a student loan has the same consequences as failing to pay off a credit card, affecting your credit rating and your future loan prospects. Those who default on federal student loans may also face wage garnishment.

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 fall. That means new credit applications may be denied, or approved only at a higher interest rate charged to riskier borrowers.

A bad credit rating can follow you in other ways. Potential employers, especially for any employee needing a security clearance, and potential landlords, often check the credit score of applicants.

Next, You’re "in Default"

Once payment is at least 270 days late, the loan will end up in default. About one-third of federal student loan borrowers have been in default at some point.

Borrowers who don't enter a loan rehabilitation agreement with Default Resolution Group at the department's Office of Federal Student Aid, you may eventually be subject to withholdings of tax refunds and other federal payments as well as garnishments of up to 15% of take-home pay.

Deferment or Forbearance

A good first step is to contact your lender as soon as you realize that you may have trouble keeping up with your payments. The lender may be able to work with you on a more attainable repayment plan or help you obtain deferment or forbearance on loan payments.

Temporary Aid for Student Loan Borrowers

Student loan payments and the accumulation of interest on outstanding loans were suspended by the Department of Education (DOE) as a COVID-19 relief measure.

In November 2022, the DOE extended the pause on federal student loan payments in response to a federal court order blocking the White House’s student loan forgiveness plan.

Student loan payments will resume 60 days after the department is permitted to implement the program or the litigation is resolved. However, if the program has not been implemented and the litigation has not been resolved by June 30, 2023, payments will resume 60 days after that.

Sovereign Default

Sovereign default occurs when a country does not repay its debts. Unlike an individual or corporate debtor, a country in default usually cannot be compelled to satisfy its obligations by a court, though it faces a variety of other risks and problems.

The economy might go into recession, or the currency might devalue. The defaulting country may be shut out of debt markets for years to come.

Sovereign default can occur for a variety of reasons, including political unrest, economic mismanagement, or a banking crisis. In 2015, Greece defaulted on a $1.73 billion payment to the International Monetary Fund (IMF) before securing additional debt relief from 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 future transaction involving 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. If one party defaults, they could face collections actions and lawsuits, among other things.

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 a lower credit score, a numerical measure of a borrower's creditworthiness
• Reduced likelihood of obtaining credit in the future
• Higher interest rates on 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.

Real World Example

Puerto Rico defaulted in 2015 when it paid only $628,000 toward a $58 million bond payment. Damage from Hurricane Maria in 2017 exacerbated the island's economic and debt crisis.

In 2019, Puerto Rico announced plans to cut its debt to roughly $86 billion from $129 billion in the largest bankruptcy in U.S. history. The bankruptcy filing was authorized under a 2016 law passed by Congress. The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) also established a financial oversight board to oversee the territory's public finances.

In early 2022, a U.S. judge approved a restructuring plan cutting Puerto Rico's $70 billion public debt to $37 billion as part of the bankruptcy process.

The Bottom Line

Default is the failure to make required interest or principal repayments on debt. Individuals, businesses, and countries can default on debt obligations. Failure to meet payments on a mortgage, student loan, or personal loan will affect an individual's credit rating, their ability to secure future loans, and could result in the seizure of property or wages. Corporations may default by failing to meet coupon payments on bonds and sovereign default occurs when a country does not repay its debts.