Default

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.

Key Takeaways

  • A default occurs when a borrower stops making the required payments on a debt.
  • 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 expose borrowers to legal claims and may limit their future access to credit.
  • The U.S. government has paused student loan collections and accrual of interest through Aug. 31, 2022, as a COVID-19 relief measure.
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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 a borrower fails to make timely payments, the loan could go into default and the asset 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 secured with 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 will 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.

When a default involves unsecured debt, a collection agency that buys the debt may have a lien, or judgment, placed against the borrower's assets. A judgment lien is a court ruling that gives creditors the right to take possession of a debtor's property if the debtor fails to fulfill contractual obligations.

Defaulting on a Student Loan

Student loans are another type of unsecured debt. If you fail to repay your student loans you probably won't find a team of armed U.S. Marshals at your front door, as one Texas man with an arrest warrant stemming from his student debt did in 2016. 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 fall. That means new applications for credit may be denied, or approved only at a higher interest rate charged riskier 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. So do many landlords.

Next, you’re ‘in default’

Once a payment is at least 270 days late, the loan will end up in default. Most defaulted student loans are held by the U.S. Department of Education.

Borrowers who don't enter a loan rehabilitation agreement with Default Resolution Group at the department's Office of Federal Student Aid 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.

Such collections, known as the Treasury Offset Program, have been suspended until Feb. 28, 2023, as part of the federal government's COVID-19 relief measures.

According to the Department of Education, all borrowers whose student loans are delinquent or in default will be offered a "fresh start" when payments resume.

Alternatives to default

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. Note that student loan payments and the accumulation of interest on outstanding loans were suspended by the Department of Education through Aug. 31, 2022, as a COVID-19 relief measure.

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

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.

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. 

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

Real World Example of a Default

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 roughly in half as part of the bankruptcy process.

Article Sources
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  1. Corporate Finance Institute. “What Is a Default?

  2. Experian. “Secured vs. Unsecured Loans: What You Need to Know.”

  3. CNN Money. "Man Arrested by U.S. Marshals for Unpaid Student Loan."

  4. Federal Student Aid. “Student Loan Delinquency and Default.”

  5. Federal Student Aid. "Collections on Defaulted Loans."

  6. Federal Student Aid. "Debt Resolution."

  7. U.S. Department of Education. "Biden-Harris Administration Extends Student Loan Pause Through August 31."

  8. Council on Foreign Relations. "Greece's Debt Crisis Timeline."

  9. Experian. “What Happens If I Default on a Loan?

  10. Experian. “Does Your Credit Score Go Up When a Default Is Removed?

     

  11. CNN Money. "Puerto Rico Just Defaulted for the First Time."

  12. U.S. Government Accountability Office. "Puerto Rico: Factors Contributing to the Debt Crisis and Potential Federal Actions to Address Them."

  13. NBC News. "How Close Is Puerto Rico to Ending Its Bankruptcy? Here Are 3 Things to Know."

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