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.
- 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.
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.
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.
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 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.
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. 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. 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.
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.
Student loan payments and the accumulation of interest on outstanding loans were suspended by the Department of Education as a COVID-19 relief measure.
In November 2022, the Department of Education 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.
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 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
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.
What Happens When You Default on a Payment?
When you default on a loan, your account is sent to a debt collection agency that tries to recover your outstanding payments. Defaulting on any payment will reduce your credit score, impair your ability to borrow money in the future, will lead to fees, and possibly result in the seizure of your personal property.
How Long Does a Default Stay on Your Credit Report?
Defaults stay on your credit report for seven years. This is the standard time that a default will be removed. A default may be removed earlier if it can be proven that it was a mistake. Once it is removed, your credit score should improve.
What Is an Example of a Default?
A default is a missed or multiple missed payments on money that you have borrowed. An example of a default would be not paying your credit card bill or your monthly mortgage payment.
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, and ability to secure future loans. Corporations may default by failing to meet coupon payments on bonds and sovereign default occurs when a country does not repay its debts.