Default in Finance Explained for Dummies

What is a default?

In finance, a default occurs when borrowers fail to meet debt obligations in one way or another.

A default can happen when a borrower, among other things:

• is unable to pay the debt in agreed times,
• does not pay the amounts as agreed upon,
• misses payments, or
• avoids or terminates payments.

The time or situation a default occurs depends on the terms agreed upon by the lender and the borrower. For example, some lenders allow only one missing payment before default comes into play, while others default only after three or more missing payments.

Defaults on secured and unsecured debt

Defaults can occur on secured and unsecured debt.

Defaults on secured debt

Secured debt (loans) require collateral as security for the debt, a type of protection for the lender. Typically, collateral comprises assets such as a vehicle or home on which the lender has a legal claim to cover the debt.

If a borrower defaults on a secured loan, the lender is allowed to seize the collateral in order to recover some or all of the outstanding debt.

For example, if a mortgagor defaults on a mortgage loan on his/her home, the mortgagee is permitted to reclaim the home that serves as security for the mortgage loan. The home would be auctioned off and the income received used to repay the outstanding amount or a portion of the outstanding amount on the mortgage loan.

In the same way, with regard to a defaulted vehicle loan (auto loan), the lender is allowed to repossess the vehicle and put it on an auction to recover all or some of the outstanding debt.   

A boat loan is another example of a secured loan.

Defaults on unsecured debt

Unsecured debt is a type of loan that does not require any type of collateral. Borrowers are granted loans based on criteria such as:

• a borrower’s creditworthiness,
• the strength of a borrower’s credit score,
• the quality of a loanee’s financial record,
• an individual’s financial capacity (income and current debt),
• a borrower’s employment history, and
• references.

Examples of unsecured loans are credit cards, personal loans, medical bills, and student loans.

There is more risk involved in unsecured loans than in secured loans. Hence, interest rates are higher, and higher credit scores are required for approval.

Usually, if a borrower defaults on an unsecured loan, the lender or creditor can refer the loan to its collections department or appoint a collection agency to collect the debt.

If a borrower still does not cooperate to repay the debt, the lender/creditor may hand over the borrower to an attorney who may take the borrower to court if he/she is still defaulting on his/her debt.

Consequences of debt default

Defaulting on debt can cause dire consequences that can have long-lasting effects such as:

• A borrower’s credit history will be negatively affected, lowering his/her credit score.
• Chances to obtain credit in the future will considerably be reduced.
• Higher interest rates on existing debt as well as any debt in the future.
• Possibility of bankruptcy.
• Debt default causes additional fees that need to be paid, for example, fees for late payments.
• A garnishment in which a court orders a third party to deduct payments directly from a borrower’s salary or bank account to repay a lender or creditor.
• Defaulting on a vehicle loan puts a borrower in danger of having his/her vehicle repossessed and auctioned. In addition, if the amount raised at the auction is less than the amount owed, the defaulter will still be responsible for the difference, plus expenses involved to auction the vehicle.
• A default on a mortgage can lead to a foreclosure on the mortgagor’s home and eventually eviction.
• Lawsuits if negotiations and all means of collecting the debt have failed.
• Annoying, and even irritating debt collectors, who harass borrowers with calls to get the payments.

Avoiding a debt default

Debt defaults can often be avoided if the following actions and precautions are considered and applied when necessary:

• Manage your borrowing. Only borrow money after you have done your homework, making sure you will be able to repay your debt (the interest and the capital) on time.
• Prepare and follow a budget, preferably a monthly one. It is important to stick to your budget, preventing you to spend more money than what is available.
• Live within your financial limits. Do not try to keep up with the Joneses, buying stuff that you cannot afford and do not need.
• Create an emergency fund. Try to save a (small) amount of money every month for times of unforeseen difficulties and needs – the rainy days, as it is commonly called.
• Keep track of your debts. Create a form that describes every type of debt, the payment dates, the duration of the loans, and the interest rates charged on the different loans.
• If possible, try to pay more than the minimum on your debt repayments.
• Understand your loan and loan agreement. This implies working through the agreement and reading and understand the small print.
• When realising that you start struggling to make timely payments on your debt, consider the following possibilities:
• Negotiation with your lender for a lower interest rate.
• Debt consolidation, meaning consolidating all your debts into one loan.
• Ask for help from friends or/and the family.
• Refinancing of your mortgage loan. However, make sure that such a step is financially sound.

Finally, some wise sayings about debt

• ‘If you think nobody cares if you’re alive, try missing a couple of car payments’ (Earl Wilson – American journalist and author)
• ‘The only man who sticks closer to you in adversity than a friend is a creditor.’ (Unknown)
• ‘Debt can turn a free, happy person into a bitter human being.’ (Michael Mihalik – Author of Debt is Slavery)