What is Defaulting on a Loan and How Does it Work?

Almost everyone will take out at least one loan in their life, and most business owners have to take out at least one business loan to pay for property purchases, equipment, and more. Loans allow you to get the cash you need to take dramatic actions or start your business now rather than saving up money for decades on end.

But while loans can be great tools for meeting your entrepreneurial goals, getting a college degree, or buying a new car when you need to make your work commute, they also come with risks if you default on the repayments. Defaulting on or failing to pay back a loan can result in huge penalties, including the decimation of your credit score, wage garnishment, and even repossession of any purchased assets.

Not sure what defaulting on a loan is, how it works, or how you can avoid it? Fortunately, this guide will break down the answers to all three questions and more. Let’s get started.

Defaulting on a Loan Explained

When you “default” on your loan, you essentially fail to pay it back on time based on the loan’s initial conditions or requirements. This can include either failing to make a payment at all or making a payment of less than the minimum payment amount as specified by the loan contract.

For example, say that you have a basic credit card bill that requires you to pay $25 per month toward whatever balance may exist, or pay off the balance entirely if it is less than $25. Your bill’s due date is July 2.

If you don’t pay your bill back by July 2, you default on the loan. If you pay $24 instead of $25 by July 2, you are still technically in default. 

Luckily, the majority of lenders and credit card companies do provide so-called “grace periods”. During these periods, you can make late payments without getting a penalty if it’s your first mistake. 

So if you’ve made regular credit card payments over the last year and simply forgot to pay your bill on July 2 one time, your credit card company might let you make the payment on July 4 without charging you a fee.

However, the grace period policy varies heavily from lender to lender. So you can’t always count on it to cover these types of mistakes.

Delinquency vs Defaulting

For the majority of lenders and credit card companies, a borrower missing one payment is not enough to bring them into full “default.” Instead, a person who misses a payment or doesn’t pay the minimum amount for their loan will be in “delinquency.”

Delinquency is the period between failing to make a payment on your loan and going into full default. It is also called the past due period of time. In most cases, delinquency time frames are marked by regular fees or other penalties that gradually increase in cost, such as decreases in your credit score.

If you fail to repay your loan or pay off delinquency fees, you could go into full default and face additional late fees and penalties (more on those below).

Defaulting Timeframes by Loan Type

Different types of loans have different default timelines or deadlines. Again, missing a single payment on your loan is not likely to send you into default (though it depends). You have to miss successive payments for you to go into default with your loan or credit card.

Loan types and the typical deadlines at which you default on the loan payment are outlined below:

  • Student loans – 270 days
  • Credit cards – 180 days
  • Mortgage payment – 30 days
  • Auto loans – 1-30 days depending on the company

Remember, each of these defaulting timeframes starts the day after your bill is due.

No matter what the default timeline is, you should try to avoid defaulting on your loans wherever possible. The consequences can be very severe and make acquiring another loan or credit card all but impossible in the future.

How Does Defaulting on a Loan Work? 

When you default on your loan, the lender or credit card company decides that they can no longer expect you to repay your debt, so they categorize the loan as “defaulted.” This results in several immediate consequences and penalties.

Collateral attached to the loan will become the legal property of the lender and can be seized by the lender or another company. Unsecured loans can incur other types of penalties, such as garnishing your wages in order to pay back the debt over time.

A borrower doesn’t decide when a loan defaults. It is up to the discretion of the lender if one or more payments have been missed. Once a loan has defaulted, it’s very difficult to pay it back without facing penalties.

In some rare cases, borrowers may be able to immediately pay back the loan’s full amount or set up a repayment plan if they are alerted to its defaulted state. This way, they can avoid some of the harsher penalties (although their credit scores will likely still be negatively impacted). 

Consequences of Defaulting on a Loan

There are a variety of consequences you could face if you default on one or more loans. These consequences are often dependent on the type of loan in question. They include:

  • Wage garnishment, which is typically applied to defaulted student loans. With wage garnishment arrangements, a portion of your paycheck will be automatically subtracted each time you’re paid until the loan’s total (and any applicable added fees) are paid off.
  • Home loan foreclosure in the case of mortgage loans. In these cases, lenders take ownership of homeowners houses, forcing you to leave and find other arrangements. Depending on the lending company in question, they may try to sell the house to another person or auction it to another real estate buyer to recoup some of their losses on your outstanding balance.
  • Lawsuits, as may be applied to defaulted personal loans or credit cards. Lawsuits can be expensive, both in terms of attorney’s fees and court costs and in what you may be required to pay to your lender if the court finds you guilty of failing to repay your loan or credit card balance.
  • Repossession of purchased items; This includes cars, TVs, and other expensive items. For example, if you default on your auto loan, the lender may seize control of the car and sell it to another person to recoup some of their costs.
  • Collateral asset seizure if your loan is secured. Secured loans use collateral in the form of possessions or property as a way of guaranteeing that the lender gets something if you fail to repay your loan. Should you default on secured loans, any collateral will become the property of the lender.
  • Revenue garnishment; This is a variety of wage garnishment. Businesses that fail to pay back business loans may be required to pay a percentage of their revenue to their lender by court order until the original loan is paid off. Fortunately, this can also help with loan rehabilitation.
  • Credit rating hits. Your credit score will almost always be negatively impacted if you default on any type of loan. Since your credit score is a measure of how creditworthy you are or how trustworthy you are to credit bureaus, acquiring another loan is very difficult or impossible. It often takes years to rebuild your credit score after it has sustained significant damage. During this time, you may need to use bad credit loans, which often come with high fees, unfavorable terms, and high interest rates.

As you can see, there are far too many potential consequences to handle. This is why it’s important to take out loans carefully and responsibly, as well as pay them back within the amount of time you’re asked.

Summary

In the end, defaulting on a loan is a stressful and harrowing process. It can lead to long-term financial and economic consequences for you and/or your business, so it’s best to avoid defaulting on any loans whenever you can.

But it’s also a good idea to avoid taking out potentially predatory or costly loans in the first place. Business loans that are worth your time will also be manageable and flexible for your needs. If you’re looking for such business loans, look no further than Seek Capital.

Not only can we offer a variety of financial solutions for your business, but we can also help you strategize to avoid defaulting on loans in the future. Contact us today and get in touch with our financial experts for more information.

 

Sources:

studentaid.gov › manage-loans › default Student Loan Delinquency and Default | Studentaid.gov

What Happens If You Default on a Loan? | US News – U.S News & World Report Money

Loan Defaults– Getting Rid of Debt when Defaulting on Your Loans | Debt.org

What Does it Mean to Default on a Loan? | Experian.com

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