A default is when a borrower has failed to meet the obligations of their loan or credit product. This can lead to late fees and negative marks on your credit history.
What Is A Default?
Over the last decade, the growth of financial technology has led to a significant increase in the number and volume of personal loans extended to borrowers. At the beginning of 2019, the outstanding balance of personal loans in the United States had almost doubled since 2015 to nearly $140 billion, with the average amount owed per borrower being approximately $8,400.
Of these, approximately 3.4% are considered to be in default, which means that the personal loan was not repaid on time. Since there are more than 21 million active personal loans in the U.S. This means that at least 714,000 are in default.
Read on to find out what a default on a personal loan is, its consequences, and how to avoid these situations.
A default is when a borrower has failed to pay for a certain number of installments associated with a personal loan (or any other type of loan). However, the specific number of failed payments required to default on a loan varies from one lender to another depending on the specifics of the loan contract and often times the laws of a particular state
Typically, a default occurs if a borrower doesn’t have the means or willingness to resume payments within 90 days. After this period, the lenders tag the loan as default, which remains on a person’s credit report for up to seven years.
What Are the Consequences of a Default on a Personal Loan?
Since a default negatively affects a borrower’s payment history, it damages their creditworthiness. In addition, the specific effects of a default vary depending on whether the loan was secured or unsecured.
Consequences of Defaulting on a Secured Loan
A secured personal loan is when a borrower has backed the loan with an asset, such as a car, jewelry, or anything else the lender is willing to receive as collateral. In the event of a default, the lender can take possession of the collateral to obtain funds that may offset a portion of the outstanding debt (or the entire value), and this is why most secured personal loans have lower interest rates than unsecured ones.
Under the terms and conditions of a secured personal loan, if a borrower defaults, the lender has the right to seize the asset involved. In some cases, however, the lender may reverse the seizure if a payment plan is negotiated, but the borrower’s credit score will still be affected by the default.
Consequences of Defaulting on an Unsecured Loan
Lenders grant an unsecured personal loan to a borrower based solely on their appraised creditworthiness, which is assessed by evaluating their credit score, past credit experiences, outstanding debt, employment situation, and other variables that may provide valuable insight into the candidate’s payment capacity.
From a lender’s perspective, unsecured personal loans are riskier than secured loans as there’s no collateral they can seize to compensate for the pending balance. For this reason, unsecured personal loans usually have higher interest rates than secured ones.
Most lenders are willing to approve unsecured loans only to candidates who can demonstrate a positive credit history. While there is no assurance that the borrower will meet their commitments, the probability of these borrowers incurring a default is lower.
Defaulting on an unsecured personal loan will negatively affect a borrower’s credit score. Additionally, the credit account may be sent to a collection agency, and the borrower could be taken to court as part of the agency’s effort to collect the debt.
Finally, defaulting on a personal loan can also compound late payments and accumulated interest charges, further increasing the amount of debt.
As a result, the amount of debt could end up being significantly higher than the initial pending balance, and, if the borrower faces a court ruling that imposes an immediate repayment or wage garnishment, the final payment will probably be larger than expected.
These consequences can affect not only a borrower’s current credit and financial situation but also their future capacity to access credit. Additionally, the cost of borrowing after a person defaults on a loan tends to increase since lenders see the borrower as more riskier
Does A Default Affect My Credit Score?
Since a borrower’s payment history accounts for 35% of their credit score, a default could lead to a severe drop. Additionally, increasing these scores in a short period can be difficult as defaults stay on credit reports for up to seven years, which means that they will affect the borrower’s future possibilities to access new lines of credit.
How to Prevent a Default
To avoid the negative consequences of a default, there are many ways that a borrower can prevent a default from ever occurring. Most of these measures involve establishing certain habits, but they also incorporate the use of technology to assist you in paying your financial commitments on time.
Set Automatic Payments
Most banks nowadays offer the option of setting auto payments through your online banking account. These payments will be triggered at a certain date before the due date of the loan.
You could also set an alert that will send you an email or SMS to inform you about the payment before it is charged. This can be helpful to check whether you have the balance on your account to pay for the commitment along with your other daily expenses.
Borrow Wisely
Borrowing money is part of most Americans’ day-to-day lives, and it is not necessarily a bad habit unless you don’t have the means to cover for the installments associated with the debt you are taking.
To avoid over-borrowing, consider calculating your monthly budget to make sure you can actually cover a new personal loan or using a higher percentage of your existing credit accounts. Borrowing within your means is essential to maintain a healthy financial situation.
Build an Emergency Fund
Unexpected circumstances could happen to anyone, such as a sudden illness or losing a job. It is impossible to predict a situation like this, but it is possible to prepare for it by building an emergency fund to help you fulfill your financial commitments.
One way to do this is to set aside a certain amount of money that can be automatically withdrawn at a certain point during the month and transferred to a separate bank account.
Communicate with Your Lender
Lenders usually prefer to renegotiate the conditions of a loan instead of having to go through the process of flagging your account as delinquent or sending it to a collection agency, as they will only obtain a few pennies on the dollar for the outstanding balance of your debt.
If you ever find yourself struggling to pay installments, try reaching out to your lender to let them know about the situation. Most lenders may be willing to extend your credit term to reduce the size of the installments, or they could even extend you a grace period if the circumstances permit it.
Defaulting on a loan can be avoided by exploring possible alternatives with your lenders to undertake payments you can more easily afford.
Look for Assistance
If you don’t feel comfortable with drafting a budget yourself, you could try talking to a financial planner or an advisor who can help you in organizing your finances to make sure you are capable of fulfilling your debt payments.
They can also propose alternatives, such as debt consolidation or balance transfers, which could reduce the overall interest rate paid on your debt, or at least refinance the terms of the personal loans you currently hold.
Bottom Line
Defaulting on a personal loan means that a borrower has failed to pay for a certain number of the installments due on the debt. The consequences of such a situation include a reduction of your credit score, the seizure of any assets committed as collateral for the loan, and potential lawsuits.
By implementing some of the measures outlined above, a borrower can reduce the likelihood of incurring a default, which would help to prevent its negative consequences.