If you’re behind on debt payments or struggling financially, a loan default can be a scary possibility looming on the horizon.
The rate of defaults on consumer loans reached record lows during 2020 and 2021, despite the broader economic downturn. This counterintuitive phenomenon was due in part to the government’s COVID-19 relief initiatives like stimulus payments and enhanced unemployment benefits.
But, as those initiatives are drawing to a close, banks are seeing borrower defaults slowly rise up again from pandemic lows. For example, Wells Fargo has started to see “very, very small amounts of delinquency increases,” CEO Charles Scharf said at the Goldman Sachs U.S. Financial Services Conference in December 2021.
Defaulting on a loan can have a serious negative impact on your financial life, from tanking your credit score, to losing your home or car, to lawsuits and even wage garnishment. But if you take steps now to work out an agreement with your lender, you may be able to get your debt under control and avoid the worst consequences of default.
Here’s what to know.
What Does It Mean to Default on a Loan?
Defaulting on a loan means that you’ve failed to make payments according to your loan agreement and the lender believes that you do not intend to make further payments. Unlike a delinquency, which can happen after a single late or missed payment, a default is much more serious and fundamentally changes the nature of your loan.
Most lenders will start reporting missing payments to the credit bureaus after 30 days, says Amy Lins, vice president of enterprise learning at Money Management International, a non-profit credit counseling agency based in Sugar Land, Texas. If you keep missing payments, your lender will consider the loan defaulted. For private loans like personal loans or private student loans, it’s up to the creditor to determine how much time can pass before the loan is considered to be delinquent or in default, says Lins.
Defaulting can have serious consequences on your credit score and finances. Because of this, if you’re currently in delinquency or can’t make payments on a loan, it’s best to reach out to your lender to discuss alternative options instead of letting your loan go into default.
How Loan Default Works
Though default and delinquency are sometimes used interchangeably, the two terms mean different things. As soon as you miss or are late on a payment, your loan is considered delinquent, says April Lewis-Parks, director of corporate communications of the national non-profit credit counseling organization Consolidated Credit. Depending on the terms of your loan agreement, a delinquency can result in late payment fees or other penalties, but it typically won’t affect your credit score until you’re more than 30 days late on a payment.
If you’re behind on loan payments due to financial difficulty, contact your lender directly as soon as possible to try to work out an agreement before your loans go into default.
Once you’ve been delinquent for a certain amount of time, your loan will go into default and your lender will start making moves on getting that money back. It’s ultimately up to the creditor how they handle their bad debt, Lins explains. They might try to contact you through their own in-house collections team or work with a third-party collections agency. As a last resort, they may sell it off at a discount to a debt collections agency, who would then own the debt and can try to collect from you.
Depending on the specific type of loan, the lender may also take other actions after a loan has gone into default. Some examples include:
Car loans: Car loans are secured by your vehicle, which means that if you don’t make payments, your lender will repossess your car and try to sell it to recoup their losses. If the car’s resale value doesn’t cover the outstanding amount, lenders also have the option to take legal action and get a judgment against you for the difference, says Lins. For example, if you owed $17,000 on a defaulted car loan and the lender was only able to sell the car for $15,000, they might take legal action to get the remaining $2,000 from you.
Mortgages: Because your mortgage is backed by your home, which serves as collateral, defaulting on your loan will result in the lender seizing your property through a process known as foreclosure. The exact foreclosure process will vary depending on your state’s laws. Some states require a judicial foreclosure, which requires the lender to get a judgment from the courts, while other states allow for non-judicial foreclosures, which does not require the lender to go to court and thus may proceed much faster.
Student loans: When private student loans go into default, they’re typically treated the same as personal loans and credit cards. But federal student loans go through a different process. After 30 days have passed since you last made a payment, a federal loan is considered delinquent. When it hits the 270-day mark, it’s considered to have defaulted. Student loans are unique in that the federal government can garnish your wages without needing a court order if you default, while most other types of debt require a creditor to take you to court first.
What Are the Penalties or Consequences of Defaulting on Loan?
Depending on the type of loan that you default on, you could face serious consequences ranging from damaged credit score to asset seizure to potential legal action. Here are some of the most common consequences of loan default:
- Damaged credit score: No matter what type of loan you default on, you’ll almost certainly see a serious and long-lasting negative impact on your credit score. Your payment history makes up 35% of your credit score, and a default can stay on your credit report for up to seven years. This could make it harder to qualify for new credit in the future.
- Asset seizure: If you default on a secured loan — a loan that’s backed by collateral — then the lender can seize the asset you used as collateral and sell it to recoup the cost. Common secured loans include mortgages, which use your house as collateral, and auto loans, which use your vehicle as collateral. Home equity loans and HELOCs are also secured loans backed by your house. Some personal loans may also be secured, with the exact collateral required varying by lender. Losing your home or car can upend your life, which is why it’s especially important to avoid letting secured loans go into default if you can.
- Legal action: If you default on a loan, your creditor could take you to court to recover the amount owed. The exact process depends on the laws in your state, but if your creditor can secure a court order, they may be able to collect your personal assets or garnish your wages.
- Wage garnishment: While most types of debt require a creditor to secure a court order before they can garnish your wages, federal student loans are different. If you default on a federal student loan, the federal government can garnish up to 15% of your disposable income to pay your debt without taking you to court. The government can also do a treasury offset, says Lins, where it takes money out of your tax refund or social security benefits to pay your debt.
How to Get Out of Default
1. Reach out to your lender
If you anticipate not being able to keep up with loan payments, contact your lender as soon as you can. Explain your situation and see if you can negotiate a payment plan to get back on track. Most lenders would rather work with you to find a solution before you go into default, rather than go through the expense and hassle of collections.
Especially in the current environment, “lenders are really willing to work with people,” Lewis-Parks says. “So [consumers] shouldn’t be afraid to reach out. It’s never going to make the situation worse.”
If you’re behind on your mortgage, talk to your lender about options to avoid foreclosure. You may be able to enter a forbearance agreement, where the lender allows you to reduce or pause payments for a certain amount of time. Or, you could work out a loan modification, where the lender adjusts the loan terms to lower your monthly payment.
2. Rehabilitate or consolidate your federal student loans
There are two main ways to get out of default on a federal student loan: rehabilitation and consolidation.
Under rehabilitation, you’ll work out a new repayment plan with your loan provider that’s based on your discretionary income. After nine on-time monthly payments under a rehabilitation agreement, your loan will no longer be in default and the record of default will be removed from your credit report.
Loan consolidation allows you to consolidate your defaulted federal loans into a new Direct Consolidation Loan and repay the new loan under an income-driven repayment plan.
A third, but less common option, is to repay your defaulted loan in full. This likely won’t be feasible for most borrowers, but it could be an option if you’ve previously defaulted on your loan but have since received a sudden windfall and now have the funds to pay it back completely.
3. Seek help if you need it
If you’re feeling overwhelmed by debt or don’t know where to start, consider seeking help from a non-profit housing or credit counseling agency. A professional counselor can advise you on your options, help you strategically prioritize your debt, and help you negotiate with your creditors or come up with a debt management plan.
“One of the things we really do is help [consumers] break that cycle of inaction, understand what their choices are, help them make a plan and move forward,” says Lins.
Some credit counseling organizations may charge a small fee for their services, but it can typically be waived if you have financial hardship.
A housing counseling agency offers guidance related specifically to housing — including mortgage default and foreclosure — while a credit counseling agency can offer help with multiple types of debt, from credit cards to personal loans to student loans.
- You can find a housing counselor approved by the U.S. Department of Housing and Urban Development (HUD) through HUD’s website.
- You can find an accredited credit counseling agency through the National Foundation for Credit Counseling (NFCC)’s website.