The failure to pay required interest or principal repayments on a loan or security debt constitutes default. It is possible for individuals, businesses, and even nations to default on their debt obligations. Creditors give significant consideration to default risk.
Defaults can occur on secured debt, such
as a mortgage loan secured by a house, or on unsecured debt, such as credit
cards or a student loan. Defaults expose borrowers to legal claims or may limit
their future access to credit. As a COVID-19 relief measure, the United States
government has paused student loan collections and the accrual of interest
through August 31, 2022.
Default Explained
It is possible for a debt that is secured
by collateral, such as a mortgage loan secured by a home or a business loan
secured by the assets of a company, to go into default. It is possible for a
loan to go into default if the borrower does not make their payments on time.
If this happens, the collateral that was used to secure the loan could be at
risk. A company would also be considered to be in default if it was unable to
make the required coupon payments on its bonds.
Defaults are also possible with unsecured debts like the balances on credit card accounts. A borrower's credit rating will suffer as a result of a default, which may make it more difficult for them to obtain credit in the future.
Default definition
To fail to do something or else be somewhere when it is required or expected.
• To fail to make the payment when due.
• To fail to appear in the court when required.
• To fail to take part in or the finish a contest.
Defaulting on Secured Debt vs. Unsecured Debt
When a person, a company, or a country
fails to pay back a debt, the entity's creditors or investors have the legal
right to file a lawsuit to recoup their losses. Their chances of financial
recovery will be partially determined by whether or not the debt is secured by
collateral.
Secured debt
In the event that a borrower fails to make
their mortgage payments on time, the lending institution has the legal right to
foreclose on the property that serves as collateral for the loan. In the event
that an auto loan borrower falls behind on their payments, the lender has the
right to reclaim the vehicle. These are some examples of loans that require
collateral. When a borrower takes out a loan that is secured by a particular
asset, the lending institution is given a legitimate claim to that asset.
In order to prevent the loss of
collateral, companies that are behind on their secured debt can seek bankruptcy
protection. This buys the companies some additional time to negotiate a
settlement with their creditors.
Unsecured debt
Unsecured debts, such as medical bills and
credit card balances, are also susceptible to defaulting on their payments.
Even though an asset is not used to secure an unsecured debt, the lender still
has a legal claim in the event that the debt goes into default. It is common practice
for credit card companies to wait several months before declaring an account to
be in default. If an outstanding balance was left unpaid for a period of six
months or longer, the lender would be required to "charge off" the
debt. This means that the lender would regard the debt as a loss and close the
account. The charged-off debt may then be sold by the creditor to a collection
agency, which would make subsequent attempts to collect the debt from the
borrower.
When a borrower fails to make payments on
an unsecured debt, the collection agency that buys the debt may be able to have
a judgement or lien placed against the borrower's assets. A judgement lien is a
court ruling that grants creditors the right to take possession of a debtor's
property if indeed the debtor fails to fulfil contractual obligations. If a
debtor fails to fulfil contractual obligations, the creditor may file a
judgement lien against the debtor's property.
Defaulting on a Student Loan
One more kind of unsecured debt is
represented by student loans. If you fail to repay your student loans what you
have borrowed, you probably won't find a team of armed U.S. Marshals at your
front door like one man in Texas who had an arrest warrant stemming from his
student debt did in 2016. However, if you do fail to repay your student loans,
you may find yourself in a similar situation as the man in Texas. However,
ignoring that debt is still a very poor course of action to take.
The results of not paying back a student
loan are comparable to those of not paying off a credit card bill in the vast
majority of respects. However, there is a significant aspect in which it can be
significantly worse. The majority of student loans are guaranteed by the federal
government, and debt collectors can only fantasies about having the same powers
as the federal government. It's possible that it won't be quite as bad as
having armed marshals show up at your door, but things could still get very
uncomfortable.
First, you're 'delinquent'
When your payment on a loan is more than
90 days past due, the payment is considered delinquent. This fact is
communicated to the three most significant credit bureaus. Your credit score
will sure to go down as a result of delinquent. This means that new applications
for credit may be denied, or approved only at a higher interest rate than would
normally be charged to riskier borrowers.
A poor credit rating can have
repercussions in other areas of your life. Credit scores are frequently checked
by prospective employers, particularly when the position being filled requires
the applicant to have a security clearance. As do a good number of landlords.
Next, you're 'in default'
When a payment is more than 270 days
overdue, the loan is considered to be in default status. The United States
Department of Education is in charge of collecting the majority of delinquent
student loans.
Borrowers who do not enter into a loan
rehabilitation agreement with the Default Resolution Group at the department's
Office of Federal Student Aid may eventually be subject to having their tax
refunds and other federal payments withheld, in addition to having up to 15% of
their take-home pay garnished. This is the case if the borrower does not enter
into an agreement with the Default Resolution Group.
As a part of the COVID-19 relief measures
taken by the federal government, these collections, which are part of a program
called the Treasury Offset Program, have been halted until February 28, 2023.
When payments on student loans are
resumed, the Department of Education states that all borrowers who have student
loans that are overdue or in default will be given the opportunity for a
"fresh start."
Alternatives to default
As soon as you become aware that you may
have trouble keeping up with your payments, the first step that you should take
is to get in touch with your lender. You may be able to work with the lender to
devise a more manageable plan for loan repayment, or the lender may be able to
assist you in deferring or postponing payments on the loan. It is important to
take note that, as a COVID-19 relief measure, the Department of Education has
suspended, until the 31st of August in 2022, both the payments on student loans
and the accumulation of interest on loans that are still outstanding.
You have the option of participating in
the federal student loan rehabilitation program or using the loan consolidation
service if you are currently behind on your federal student loans.
Types of default
There are two types of default: debt services default and technical default. The borrower has defaulted on debt service when he or she has failed to make scheduled payments of principal or interest. Technical default is the violation of an affirmative or negative covenant.
Affirmative covenants are clauses in debt contracts which require companies to maintain specific capital levels or financial ratios. The restrictions in affirmative covenants most frequently violated are tangible net worth, working capital/short-term liquidity, and debt service coverage.
Negative covenants are clauses in debt contracts that restrict or prohibit corporate actions (such as the sale of assets or the payment of dividends) that could harm the position of creditors. Negative covenants may be either continuous or based on incurrence. Negative covenant violations are uncommon compared to violations of positive covenants.
With the majority of debt (including corporate debt, mortgages, and bank loans), the debt contract stipulates that the total amount owed becomes immediately due upon the first instance of a payment default. Generally, if the debtor defaults on any debt owed to the lender, the cross default covenant stipulates that this particular debt is also in default.
Upon an uncured default in corporate finance, the holders of the debt will typically initiate proceedings (file an involuntary bankruptcy petition) to foreclose on any collateral securing the debt. Debt holders may still file for bankruptcy, even if the debt is not secured by collateral, to ensure that the company's assets are used to repay the debt.
There are a variety of financial models for analyzing default risk, including the Jarrow-Turnbull model, Edward Altman's Z-score model, and Robert C. Merton's structural model of default.
Sovereign default
When a nation fails to meet its financial
obligations, this is known as a sovereign default. A country that has defaulted
on its debts, as opposed to an individual or a corporation, cannot typically be
ordered by a court to fulfill its obligations, despite the fact that it is
subject to a wide variety of other dangers and issues.
There is a possibility that the economy
will enter a recession, or that the value of the currency will decrease. It's
possible that the defaulting nation will be barred from the debt markets for
many years to come.
Orderly default
In times of severe insolvency crises, it may be prudent for regulators and lenders to proactively engineer the methodical restructuring of a country's public debt, also known as "orderly default" or "controlled default." Experts who advocate for this solution to a national debt crisis generally argue that a delay in organizing an orderly default would end up harming lenders and neighboring nations even more.
Strategic default
A strategic default occurs when a debtor chooses to default on a loan despite being able to service it (make payments). This is typically done for nonrecourse loans, in which the creditor cannot make other claims against the debtor; a common example is negative equity on a mortgage loan in common law jurisdictions like the United States, which are typically nonrecourse. In this latter scenario, default is colloquially referred to as "jingle mail" because the debtor ceases making payments and generally mails the keys to the creditor, typically a bank.
Sovereign strategic default
Even if they are able to make the payments, sovereign borrowers, such as nation-states, have the option to default on a loan. President Rafael Correa of Ecuador strategically defaulted on a national debt interest payment in 2008, citing the debt's "immoral and illegitimate" nature.
Consumer default
It is common for consumers to default on rent or mortgage payments, consumer credit, or utility bills. A European Union-wide analysis identified certain risk groups, such as single-person households, unemployment (even after adjusting for the significant impact of having a low income), youth (especially those younger than 50 years old, with somewhat different results in the New Member States, where the elderly were also more frequently at risk), inability to rely on social networks, etc. Even internet illiteracy has been linked to increased default, possibly because these households are less likely to access the social benefits to which they are frequently entitled. Despite the fact that effective non-legal debt counseling is typically the preferred -more economical and less disruptive- option, consumer default can result in legal debt settlement or consumer bankruptcy procedures, the latter ranging from one-year in the United Kingdom to six-year in Germany.
According to research conducted in the United States, pre-purchase counseling can significantly reduce the default rate.
Defaulting on a Futures Contract
A futures contract is said to be in
default when one of the parties to the agreement does not fulfill the
obligations that were outlined in the contract. In this context, defaulting
typically refers to the act of failing to settle the contract by the date that
is required. A futures contract is a legally binding agreement for a transaction
that will take place in the future and will involve a specific commodity or
asset. One of the parties to the contract makes a commitment to buy at a
particular date and price, while the other party makes a commitment to sell at
the milestones that are specified in the contract.
What Happens When You Default on a Loan?
The consequences of a borrower failing to repay a loan can include the following:
Negative remarks on a borrower's credit report and a lower credit score, which is a numerical measure of a borrower's creditworthiness;
A reduced likelihood of obtaining credit in the
future. Higher interest rates on any new debt the borrower incurs.
Wage garnishment in addition to any other
applicable penalties. The term "garnishment" refers to the legal
process of instructing a third party to deduct payments directly from a
borrower's wages or bank account. Garnishment can be used in cases where the
borrower has defaulted on their payments.
According to the credit bureau Experian, a default will remain on your credit reports and will be taken into consideration in your credit scores for a period of seven years.
Default distinction from insolvency, illiquidity, and bankruptcy
The term "default" should be differentiated from "insolvency," "illiquidity," and "bankruptcy."
Default:
The debtor has missed the payment deadline for a debt for which payment was due.
Illiquidity:
The inability to pay debts with cash (or other "liquefiable" assets).
Insolvency:
Insolvency is a legal term indicating that debtors cannot pay their debts.
Bankruptcy:
A legal determination that places court supervision over the financial affairs of insolvent or delinquent debtors.
Real World Example of a Default
In 2015, Puerto Rico went into default on
a bond payment because it only paid $628,000 toward the $58 million total due.
The devastation caused by Hurricane Maria in 2017 further exacerbated the
economic and debt crisis on the island.
In 2019, Puerto Rico announced its
intentions to reduce its debt to approximately $86 billion, down from $129
billion, as part of the largest bankruptcy in the history of the United States.
The decision to file for bankruptcy was permitted by a law that was passed by
Congress in 2016. A financial oversight board was also established by the Puerto
Rico Oversight, Management, and Economic Stability Act (PROMESA), which was
given the responsibility of monitoring the public finances of the territory.
As part of the process of Puerto Rico
filing for bankruptcy, a judge from the United States granted approval to a
restructuring plan that would reduce the island's public debt from $70 billion
to $37 billion.