You may take out a loan fully prepared to pay it back, but your plans may not go according to schedule. You miss one payment, then another, and before you know it, you’ve landed in default.
Can Defaulting on a Loan Hurt You Financially?
Yes, and in more ways than one. The most immediate damage can involve your credit score, but there are other financial consequences that can follow a loan default, including a collection lawsuit and wage garnishment. If you’re in repayment on any type of loan, this guide explains everything you need to know about default.
What Is Loan Default?
There are two ways to understand loan default: from a general perspective and more specifically how it’s defined for different loan types.
“Loans go into default when the consumer fails to make loan payments when they’re due,” says John Heath, credit expert and directing attorney at credit repair firm Lexington Law. “The terms regarding default are set by the agreement the consumer signs with the lender and may vary from lender to lender.”
With a personal loan or a private student loan, for instance, your lender may consider you to be in default after one missed payment. With federal student loans, on the other hand, default may not apply until you’re 270 days late with a payment.
It’s important to understand when default can occur if you’re planning to take out a loan or you have a loan in repayment. Knowing when you may be at risk of default can help you develop an action plan for avoiding it.
[Read: Debt Consolidation Loans.]
Why Can Loan Default Happen?
While some borrowers may default intentionally by refusing to repay a loan, default can often be the result of unexpected circumstances.
“Despite people’s best intentions, life doesn’t always go as planned,” Heath says.
He says a job loss, personal or health crisis, forgetfulness or overwhelming debt levels can lead someone to default on a loan, unintentionally hurting them financially in the process. In the case of mortgages, for example, the majority of borrowers who default do so because they’re financially unable to pay their home loans, according to the Federal Reserve Bank of Minneapolis.
According to the Brookings Institution, student loan default isn’t necessarily the result of borrowing too much but can instead be linked to family and social backgrounds, undergraduate education performance, the type of school attended and borrower earnings after graduation.
For some borrowers, not knowing how to manage loans and other debts can lead to default. Josh Sheen, founder of personal finance site OMG My Money, defaulted on $77,000 in student loan debt. He attributes that to a combination of poor financial education and an inability to delay gratification.
“I was overwhelmed,” he says. “I didn’t see a way to climb out of $77,000 in student loans and became extremely unmotivated when I saw the large debt.”
Regardless of the reasons for defaulting on a loan, borrowers may face a similar set of negative impacts after the fact.
How Loan Default Impacts Your Credit Scores
A credit score is a three-digit number that lenders use to gauge your ability to be financially responsible. Your FICO credit score, the one lenders use most often, is based on five factors, the most important of which is your payment history. Late payments, and eventual defaults, can be extremely negative, says Dan Soschin, chief operating officer at credit card comparison site CardGuru.com.
“Even a few late payments can have an impact on your credit score,” Soschin says, and “defaulting on a loan will likely result in a lower credit score.”
One late payment can result in a score drop of 100 points or more. Your score can plunge lower with each additional late or missed payment the longer you remain in default. And negative marks associated with late or missed payments as a result of loan default can linger on your credit report for up to seven years from the original delinquency.
Sheen says he saw an immediate credit score hit 30 days after missing the first payment on his loans. After three months, the loans entered delinquent status, and eventually they were assigned to a collection agency. His credit score paid the price.
“My FICO credit score was crushed for all three credit reporting bureaus,” he says. His score dipped below 400 after the default occurred. It took more than a decade for him to raise his score above 700, and he paid higher interest rates on loans and lines of credit he took out in the interim. A higher interest rate usually means a higher overall cost of borrowing over time.
As a general rule, the better your credit score is before a default, the more negative impact you’re likely to experience. Someone who has a 750 credit score that drops to 650 after a default, for example, may suddenly find it harder to qualify for new credit, whereas someone whose score drops from 650 to 550 may not notice as much of a difference in credit approvals.
Heath says the credit score effects may trickle down to other areas of your life, beyond just borrowing. Default can keep you from getting new credit, “but also prevent you from obtaining such necessities as utilities, a cellphone or even a job.”
In a 2017 CareerBuilder survey, for instance, 72 percent of employers said they perform background checks on prospective hires, which may include a credit check. A low credit score could scare employers away from offering you a position, especially if the job is financially sensitive.
[Read: Best Personal Loans.]
Other Impacts of Defaulting on a Loan
While your credit score may be your primary focus, that’s not all you need to be aware of with loan default.
“You may begin receiving calls and letters from creditors and/or independent collection agencies demanding payment,” Heath says. If you don’t respond to requests for payment, a debt collector could add even more pressure to pay.
“If you don’t pay after these types of payment demands, the account could be sent to a collection attorney who may file a lawsuit against you,” Heath says. “This lawsuit could result in a judgment which would be reported to the credit bureaus, negatively affecting your score.”
As if that’s not enough, Heath says a creditor could take further action by repossessing your car if you default on an auto loan or initiating foreclosure proceedings if you default on a mortgage. In the case of a loan when there’s no collateral involved, you may face other consequences.
“Laws and procedures vary by state, but generally speaking, a lender can seek to recover lost money using the court system, which includes garnishing your wages or a levy against your bank account,” Soschin says. He notes that this type of collection action can only be enforced by the courts; in other words, a lender first has to sue you and win a judgment against you before it can claim your wages or bank account funds. In the case of federal student loans, your federal income tax refund could also be garnished.
Receiving a notice of wage garnishment from the Department of Education was the wake-up call Sheen needed to take steps to get his loans out of default. “I felt so embarrassed thinking about the conversation I might have with my company’s HR department that I immediately started taking my financial mistakes seriously,” he says.
How to Avoid Loan Default
How you handle a potential default depends largely on the type of loan involved.
Heath says if you’re in danger of defaulting on federal student loans, consider taking a deferment or forbearance period. “These alternatives permit you to temporarily stop making payments or reduce your monthly payments,” he says, affording some breathing room. However, interest will continue to accrue while your loan is in forbearance.
If you don’t want to or can’t put student loan payments on pause, switching to an income-dependent repayment plan could make your monthly payments easier to manage.
Modifying your loan may be an option if you’re worried about defaulting on a mortgage. “A loan modification may reduce your monthly payments by changing the loan from an adjustable rate to a fixed rate or extending the life of the loan,” Heath says. “Your mortgage lender may have other options that could help your situation as well.”
Soschin says it’s worth calling up your lender to ask about hardship programs if you have a difficult financial situation, such as a sudden job loss or illness, that’s keeping you from making loan payments. “The lender may be able to provide you with a grace period before you’re declared in default,” he says, “or work on a payment plan to provide you with lower payments.”
The downside, Soschin says, is that a payment plan may stretch out repayment longer, resulting in more total interest charges. But, he says, that’s a better option than defaulting.
Debt consolidation, refinancing or a zero percent annual percentage rate credit card balance transfer offer are other possibilities for managing a defaulted loan. But you may need a good to excellent credit score to qualify for the best offers. If your score has already dropped because of one or two late payments, the loans or credit cards available to you might not be good enough to manage the balance on your defaulted loan.
[Read: Best Home Equity Loans.]
What to Do If You’ve Already Defaulted on a Loan
If you’re already in default on a student loan, personal loan or other type of loan, it’s important to limit the damage. Here are some steps you can take to get back on course:
— Pay the late amount due. This can help you avoid additional derogatory marks on your credit and minimize the accumulation of fees and interest.
— Work out a new payment plan. If you have a large past due amount, you may need to restructure your payment plan in the short term to get caught up.
— Ask your creditor if there are special programs to get out of default. With federal student loans, for example, loan rehabilitation may be an option.
— Consider negotiating a settlement. If you’ve been in default for a while, your creditor may be willing to accept a settlement for less than what’s owed to resolve the debt.
— Check your credit reports and scores. Check your credit to gauge the impacts of loan default. If you’re making payments or settling a defaulted debt, check your credit monthly to make sure payments are being reported properly.
Most importantly, avoid doing nothing. “The worst thing you can possibly do is ignore the issue,” Soschin says. “Creditors prefer proactive consumers.”
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