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Loan Default: What You Need To Know And How You Can Prevent It

5-Minute ReadJune 06, 2022

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When you accept the terms of a loan, you’re making an agreement with the lender that you intend to repay the loan in full. You likely had the best of intentions when signing on the dotted line, but life has a knack for getting in the way of the best-laid plans.

If your financial circumstances have changed due to a major life event, it’s that you’re no longer able to keep up with the loan payments. With that, you may be at risk of defaulting on the loan.

But what is a loan default, and what are the consequences for it? Let’s take a closer look.

What Does It Mean To Default On A Loan?

When you can’t make your monthly payments, you’re at risk of defaulting on the loan. A loan default can happen when you fail to repay the debt within the terms of your initial loan agreement, meaning that you’re unable to fulfill the legal requirements of the loan.

Although it’s possible to go into default after a single missed payment, that’s not the norm. Instead, you’ll need to miss a succession of monthly payments for that to happen. Be advised, however, that this can vary greatly by the type of loan and by the lender.

When you miss a single monthly payment, many lenders will allow your loan to go into a delinquency phase. In this delinquency period, you’ll have time to avoid defaulting on your loan. You can do this by catching up with the missed payments or contacting your loan provider for an alternative solution of getting out of default.

You should check the specific details of your type of loan. In addition to the interest rate and payment information, your loan paperwork should outline any grace period for late payments and any late fees that you’ll need to contend with. With that information in hand, you’ll be better prepared to avoid defaulting on your particular loan.

If you have the opportunity to avoid defaulting on your loan, you should pursue it. The impacts of loan default can leave a negative legacy on your finances.

What Are The Consequences Of Loan Default?

Loan default can lead to significant ramifications. It’s critical to understand the full extent of these impacts. Let's dive into the major impacts of loan default below.

Credit Score Impacts

The biggest immediate impact when defaulting on a loan is a major dip in your credit score. Once your loan servicer reports your default to the credit bureaus, you should expect a big dent in your credit. Unfortunately, the credit impacts of loan default are dramatic and long-lasting.

In fact, a loan default can remain a dark spot on your credit report for up to 10 years. Although a single late payment can negatively impact your credit score, the credit consequences of defaulting on a loan are more significant.

A hit to your credit score can have a wider impact on your finances. As you seek out future loan opportunities, you’ll likely face higher interest rates and less favorable loan terms.

Financial Repercussions

The financial consequences of loan defaults vary by the type of loan. For example, borrowers with federal student loans will be forced to deal with loan "acceleration." Essentially, this means that if you default on a loan from the U.S. Department of Education, then the entire balance of the loan will be due immediately. If you’re unable to pay off the entire balance at once, the government may choose to withhold your tax refunds and other federal benefits until the debt is repaid.

An additional consequence of defaulting on federal student loans is the fact that you won’t be able to qualify for loan deferment or forbearance once you’ve defaulted. Finally, defaulting on a federal student loan will prevent you from qualifying for federal student aid in the future.

If you default on a secured loan, you’ll face repossession of the secured item. One example is your mortgage loan, which is secured by your home. If you default on the mortgage, then you’ll have to return the property to the lender through foreclosure. Another example is auto loans, which are typically secured by the vehicle itself. If you default on the loan, your car may be repossessed.

Legal Issues

Defaulting on unsecured loans, such as personal loans or credit card debt, will not lead to the repossession of your belongings. However, it can lead to legal action by the creditor.

The creditor has the right to sue borrowers who default on a loan. Once in court, they can push for repayment options such as wage garnishment or liens on your assets.

Personal Stress

The final burden when defaulting on a loan that’s often overlooked is your personal emotional toll. Through the process of defaulting on a loan, you may encounter debt collectors from collections agencies who call, email and text you to collect on the defaulted funds. Additionally, the pressure of avoiding default causes stressful situations.

As you wade through the process, try not to allow the financial impacts on your life to affect your mental health. Always reach out for help when you need it!

How To Prevent Loan Default

The financial, legal and emotional consequences of defaulting on a loan can leave a lasting impact on your life. With that, it’s important to avoid this situation if possible.

As you contemplate your options for avoiding default, you’ll need to consider the unique circumstances surrounding your loan. But you still have a few options:

1. Contact Your Lender

If you know that you’re heading for default, contact your lender ASAP. You might be surprised to know that some lenders are willing to work with you. You can explain your predicament and collaborate with the lender to come up with a new repayment plan.

2. Consider Deferment Or Forbearance

Depending on your lender, you may be able to use deferment or forbearance options to ease your financial pressure right now. Loan deferment allows borrowers to temporarily stop making the principal and interest payments on the loan. The duration and repayment stipulations of the deferment period varies by lender.

If you don’t qualify for deferment, a forbearance will allow you to stop making principal payments, or reduce your monthly payment, for up to 12 months. However, both of these options can have long-term financial impacts, so weigh your options with the help of your lender before moving forward.

3. Contact A Credit Counselor

Working with a credit counselor is one type of debt relief that can help you come up with a new payment strategy. If you’re struggling to make on-time payments, a credit counselor could be a helpful contact.

4. Talk To A Lawyer

If you’re already in default, then contact a lawyer to understand your legal options. It’s important to seek out legal counsel who has experience working with your specific type of loan default.

Final Thoughts

Defaulting on a loan can lead to major financial impacts for years to come. Above all, take some time to consider your loan repayment options before falling into default. It’s important to take action to prevent default if at all possible.

If you’re in danger of loan default due to COVID-19, then you should absolutely reach out to your lender. Many lenders are willing to work with borrowers who have been impacted by COVID-19.

If you’re struggling to make your delinquent loan payments, learn how to pay past-due balances and prevent a default on your loan.

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