Almost no one who takes out a loan plans to default on it. But as household debt in the U.S. continues to increase, defaults are inevitable. According to a report by the Federal Reserve Bank of New York, total household debt increased for the 19th quarter in a row to $13.95 trillion in Q3 of 2019.
The Federal Reserve also reported significant rates of serious delinquencies (meaning 90 days or more delinquent) in the 3rd quarter of 2019: 5.16% for credit card debt, 2.34% for auto loan debt, 9.26% for student loan debt, and 4.67% for other types of debt.
Those percentages might not sound significant, but they represent millions of people. For example, according to the Washington Post, 7 million Americans are three months behind on their auto loan payments. So, what does loan default mean for those who are falling behind on their debt?
In this guide:
- What does it mean to default on a loan?
- What happens when you default on a loan?
- How to prevent defaulting on a loan
- What to do if you’re already facing loan default
What does it mean to default on a loan?
First, let’s define our terms. Just because you’re a few days or even a few weeks behind on a loan doesn’t mean that you’ve defaulted.
“Loan default means that you have failed to pay the loan for more than 30 days,” says Katie Ross, education and development manager for American Consumer Credit Counseling (ACCC), a national financial education nonprofit organization.
You can also find more information regarding your lender’s definition of a default in the initial paperwork.
“The loan agreement—usually the Retail Installment Sales Contract (RISC) for the purchase of a car, or the credit card contract (CCA), will typically define what events constitute default,” says Donald E. Petersen, a Florida Telephone Consumer Protection Act lawyer.
“The most insidious form of default is ‘cross-default’”
Missed payments are the most common type of loan default. However, Petersen says this isn’t the only type. “Failure to maintain insurance or even filing bankruptcy can constitute a default,” he says.
“The most insidious form of default is ‘cross-default’—many credit card agreements provide that default on any other credit card by any issuer constitutes default under the credit card agreement.”
And this could cause a ripple effect. “So, Bank B may or may not declare a default on Credit Card B based upon a delinquent payment to Bank A and raise the interest rate payable on Credit Card B to the default rate.”
What happens when you default on a loan?
One major negative to defaulting on a loan is that your FICO credit score can drop. “This can make it very difficult for you to gain loans again in the future, meaning you may not be able to place a mortgage on a property, buy a car, or buy tickets to travel,” says Andrew Taylor, director at Net Lawman.
And defaulting on a personal loan can affect more than just your ability to get credit in the future. According to Petersen, some employers check a job applicant’s credit report, and he says a default can also determine the rate you pay for insurance.
In addition, your lenders have a right to pursue avenues to get what’s owed to them. “For an unsecured personal loan, defaulting can mean that the lender can take you to court and start garnishing your wages,” says Ross. “If you default on an auto loan, your car can get repossessed.”
Defaulting on a personal loan
“Generally, personal loans fall into the category of unsecured debt, which means there is nothing (real property like a car or house) attached to it,” says Larry Duffany, a Ramsey Preferred Coach at Raising Hope.
When you default on one of these loans, Duffany says the lender will contact you—and continue to do so—until they find that you are not going to pay the loan.
“Federal banking regulations and accounting standards require lenders to charge off the account within 180 days of the first default not cured,” says Petersen. During this 180-day period, he says lenders may use their inhouse collection agency or outsource the collection efforts.
“Many, if not most, lenders sell the delinquent accounts soon after they are charged off,” he continues. “Some other lenders hire debt collectors to attempt to collect the accounts while the lender retains ownership of the account.” This may result in having collection fees added to your debt.
Expect a lot of phone calls
You can expect a barrage of collection calls. “The callers intend for the frequency of the calls to break down the consumer and coerce payment,” Petersen explains.
If it’s a robocall, he says the borrower can instruct the caller to stop calling, and then, the caller has to cease using pre-recorded messages and/or automatic telephone dialing machines to call the borrower’s cell phone.
“The callers intend for the frequency of the calls to break down the consumer and coerce payment”
“If the caller continues to robocall a cell phone after being instructed to stop calling, the cell phone user may be entitled to receive at least $500 per call and up to $1,500 per call if the court finds that the caller willfully violated the Telephone Consumer Protection Act (TCPA),” Petersen says.
According to Duffany, depending on the size of the loan, the creditor can also take you to court when you default on a personal loan. However, Petersen says this doesn’t happen often.
“Publicly traded debt collectors have disclosed that they sue on approximately 3% of the accounts that they attempt to collect,” he says.
Defaulting on a car loan
Unlike most personal loans, car loans are a secured debt. “Failure to pay will mean that the company can seize the car until payment is received, and they may also then sell the car at auction,” Duffany says.
“If that happens, and the company loses money, they can sue you for the difference between the auction price and what your loan balance is,” he says. However, car loans are usually undersecured. “That means the collateral is not worth the amount owed on the loan,” says Petersen.
“As important as keeping the car is to most consumers, the lenders share a similar incentive to avoid the resulting expenses and loss which will result from repossessing and selling the car.”
As a result, he says car lenders want to work with consumers who are only in default by one month and have a realistic way to catch up on their late payments. “However, most lenders will repossess the collateral if the delinquency grows to 60 days.”
>>Read More: How late can you be on a car payment before repossession?
How does the repossession process work?
Petersen says the Uniform Commercial Code (UCC) will typically require the lender to inform the borrower of when, where, and how they plan to sell the repossessed property, although these requirements can vary by state.
Also, lenders have to send the borrower a written notice itemizing the charges and the surplus or deficiency resulting from the sale.
“In some states, lenders who deviate from the strict requirements of the UCC’s notice requirements are prohibited from seeking a deficiency balance, and the consumer borrower may have a claim for statutory damages in the amount of $500,” Petersen says.
“In many other states, the consumer borrower will have the statutory damage claim but will not have a defense to any deficiency balance.”
How to prevent defaulting on a loan
Think carefully before taking out a loan
Sometimes, people default because they didn’t thoroughly think through the loan.
“Take a minute to really decide whether you are able to commit to the agreement of this loan for the length of time it has been set up for,” advises Taylor. “Think of potential negative outcomes and loosely plan for the worst while hoping for the best.”
It’s understandable that some situations are out of your control. However, Ross agrees that the best way to avoid defaulting on a loan is by making sure you can afford to pay back the loan before you even take it out.
>> Read More: What to do if you can’t make car payments
Set up a budget & avoid impulse decisions
“You can do this by creating a budget if you haven’t already. That way, you know how much money you can allocate towards the loan payment while managing all your other expenses,” Ross says.
She also recommends setting up automatic payments to ensure your monthly payments are being made on time.
Our experts also warn against making emotional decisions. “Far too many consumers make poor choices in an overly emotional attempt to maintain the status quo,” Petersen says.
Avoid the temptation of credit card offers unless you can pay the balance at the end of the month (or before the 0% interest period ends).
>>Read More: Need help determining your budget? Our auto loan calculator and personal loan calculator can help.
Communicate with your lender
If you’re already late but have not yet defaulted, the first and most important step is to communicate with the lender.
“Nothing is worse than a silent debtor—lenders and creditors assume the worst,” Duffany says. He admits that not all lenders—especially auto lenders—will be accommodating, but some will help make a repayment plan.
Duffany recommends calling the lender and letting them know you’ve experienced an immediate, short-term crisis, and writing a letter of hardship detailing the problems and how you intend to address it moving forward.
What to do if you’re already facing loan default
If you’re already in default, you still need to get in touch with the lender and let them know what’s going on.
“If the problem is going to be protracted, you’ve lost a job, you’ve had to take a pay cut, you’ve been on disability, etcetera, and your pay is way down, you may ask for a forbearance,” Duffany says.
“Another way to meet the lender in the middle is to work your budget to arrive at a pro-rata amount of money to pay the lender.” While this will often work with a personal loan, he says that in situations with secured debts, lenders tend to want the whole amount or nothing.
“Don’t bury your head in the sand and hope it will go away on its own … Seek legal advice”
However, what you shouldn’t do is just ignore the defaulted loan. “Don’t bury your head in the sand and hope it will go away on its own,” says Taylor. “Seek legal advice—there are many free pop-ups around providing free legal advice—and speak to the bank or your loan creditor.”
In addition, Ross recommends speaking with a credit counseling agency to get advice on the best way forward. And don’t forget that you have rights that lenders have to respect.
“Consumers who have defaulted on their loans and wish to restore some privacy while they rebuild their lives should consult with a consumer protection lawyer to learn their rights under the Telephone Consumer Protection Act and the Fair Debt Collection Practices Act (FDCPA),” Petersen says.
>> Read More: How do personal loans work?