What is 'Temporary Default'

Temporary default is a situation in which a debt issuer fails to meet loan obligations but remains likely to resolve the situation in some way.

BREAKING DOWN 'Temporary Default'

Temporary default occurs when circumstances cause a borrower to breach one or more elements of a debt contract. For example, a short-term squeeze in cash flow may force a borrower to delay timely payment on a loan or other debt instrument. Debt issuers have a contractual obligation to make timely payments of principal and interest and to follow any debt covenants outlined in a loan contract. Any failure to meet these obligations over the course of the loan places the borrower in default.

Loan agreements typically list the consequences of default, which may include penalty payments, automatic changes to interest rates or loan termination accompanied by a demand for immediate repayment of the outstanding principal of the loan. In cases where a borrower clearly has the means, opportunity and desire to continue to rectify the situation and continue to meet loan obligations, it benefits both the borrower and creditor to take less-drastic actions. Creditors consider these situations to be temporary defaults when they can reasonably expect a borrower to meet their obligations eventually.

Risks Related to Temporary Default

In a best-case scenario, a borrower in temporary default returns to compliance with loan obligations. For example, a borrower could make back payments and return to timely payments on the debt going forward. Creditors such as bondholders might only see a delay in interest payments in this situation. The longer the delay in payment, however, the greater the risk that creditors will take a loss on some portion of their interest or principal payments. If the borrower’s troubles continue to mount and lead them to declare bankruptcy, the creditor would likely have to compete with other debt-holders to recover as much of the investment as possible. In this case, the worst-case scenario would be a total loss of outstanding interest and principal.

The distance between the best-case and worst-case scenarios covers a broad territory of default risk. Any form of default exposes borrowers to higher interest rates, since their inability to meet loan obligations makes it riskier for lenders to extend them credit. When a borrower enters temporary default, creditors may find it advantageous to offer some form of debt restructuring in order to ease repayment hardships while keeping the creditor whole.

Bond issuers may also offer bondholders an exchange, for example, swapping current bonds with lower-yielding issuances and longer durations. This arrangement benefits investors by replacing bonds in danger of default with a potentially less-risky issuance. At the same time, the issuer can begin to repair any damage to its credit rating by making timely payments over the duration of the longer loan.

RELATED TERMS
  1. Default

    Default is the failure to promptly pay interest or principal ...
  2. Default Premium

    A default premium is the additional amount a borrower must pay ...
  3. Default Probability

    Default probability is the likelihood over a specified period, ...
  4. Standing Loan

    Standing loan refers to an interest-only loan where repayment ...
  5. Debt Restructuring

    Debt restructuring is a method used by companies with outstanding ...
  6. Debt

    Debt is an amount of money borrowed by one party from another, ...
Related Articles
  1. Insights

    Why and When Do Countries Default?

    Countries can default on their debt. This happens when the government is either unable or unwilling to make good on its fiscal promises.
  2. Personal Finance

    Refinance Vs. Debt Restructuring: What's Best For Your Credit Score?

    Discover key differences between refinancing and restructuring debt in regard to terms, the negotiation process and effect on credit scores.
  3. Retirement

    5 Reasons Not to Borrow From Your Retirement Plan

    Your retirement plan should never be the first place to turn for a loan. Here's why.
  4. Insights

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  5. Taxes

    Debt Consolidation: When It Helps, When It Doesn't

    Here's the smart way to use a debt consolidation to get your financial life back on track
  6. Personal Finance

    Different needs, different loans

    When it comes to loans, there are many different types according to your needs. Find out what options are available when it comes to borrowing money.
  7. Personal Finance

    Personal Loans vs. Car Loans

    How to tell whether a personal loan or a car loan is better for you.
  8. Personal Finance

    Creative Ways To Overcome Student Debt

    There's many available student debt repayment options and strategies, such as student loan initiatives and loan consolidation plans.
  9. Personal Finance

    Use These Tips to Crush Student Loan Debt Fast

    Savvy graduates are paying off their college debt in record time. Here are the strategies that can get you out from under faster.
  10. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
RELATED FAQS
  1. Difference between delinquency and default

    Find out more about loan delinquency, loan default, and the difference between a loan borrower defaulting and being delinquent ... Read Answer >>
  2. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
  3. What factors are taken into account to quantify credit risk?

    Learn how probability of default, or PD; loss given default, or LGD; and exposure at default, or EAD, are used to help quantify ... Read Answer >>
  4. What is the difference between secured and unsecured debts?

    Learn about the differences between secured and unsecured debt — and how banks buffer risks associated with each type of ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center