What is Defaulting on Loan?

When you take a loan from a financial institution, you promise to pay it back to the lender within a specified time. However, things may not always go as you planned. Anything can happen—the most recent example being the ongoing COVID-19 pandemic situation. Unprecedented events like this can lead to a job loss, a decline in your business revenue, or even an expensive medical emergency. Under such circumstances, arranging your loan EMI might seem like a big burden. In case you fail to pay the EMI amount as per the schedule, then it is termed as a case of loan default.
 

Factors leading to a loan default

Defaulting on a loan means not paying your loan EMI after missing the first instalment. Loan defaults can happen for any type of loans such as a corporate loan, mortgage, or credit card. The borrower could be facing a monetary crunch due to:
 

1. Natural disasters which affect businesses
2. Medical emergencies like the current COVID-19 pandemic
3. Social unrest
4. Political violence
5. Social events like marriage, the birth of a child.
6. Job change
7. Personal crisis

 
Enforcing the provisions for default entirely depends on the lender. If you are fortunate, you may get an additional few months to pay up.
 

Consequences of defaulting on a loan

 
Depending on the type of loan, there are different outcomes for defaulting on a loan:
 

1. Secured loans

    It requires collateral such as your house or car which has to be mortgaged.  In case of loan default, the lender may take possession of your collateral as per the loan agreement and sell it to recoup the loan amount.
    

1. Unsecured loans

   It does not require any collateral and is based on a written consent that you will repay the borrowed amount. The lender can take legal steps against you or put your account into collections if you default for more than 90 days on the loan repayment. 

 
For both types of loans, your credit history would be negatively affected. The defaulting on a loan will reflect in your credit history for seven years since the period of the first default.

To avail unsecured business loans, you need not offer any asset as collateral. The lender may ask for a higher interest rate or a personal guarantee. If you sign a personal guarantee, you promise to repay personally if there is a default caused by your business.

Also Read: Consequences Of Non-Payment Of EMI And Ways To Avoid It
 

Defaulting on an Unsecured Loan

Unsecured loan such as personal loan, student loan or a line of credit usually comes with higher fees and interest rates as compared to secured loans. This is because of the higher risk involved for the lender as there is no collateral involved.

Most lenders allow borrower some extra time for repayment as loan recovery is a costly process. Borrower can also inform the lender and request for a loan deferment. For loan recovery, the lender has to appoint a recovery/collection agency.

The default provisions that are implemented include:
 

1. You are given a grace period of up to 30 days for making a minimum payment. No penalties are imposed.
2. For a default period of more than a month and up to two months, you have to pay the additional late fees. The interest rate may also increase.
3. If the default period is 2-4 months, your credit card account may get closed. The lender can ask for payback of the full amount and inform the recovery department.
4. If you do not repay the amount for 6 months, the lender may take legal action against you.
5. Student loans are given the longest grace period which is for 9 months. Required measures are taken after this period.

 

Defaulting on Loans Rates

Default rates are also called penalty rates. It is the higher interest rate that you have to pay in case of non-repayments. The default rate on loans includes the percentage of all outstanding loans, written off by a lender. This happens if the payment is due for more than 9 months.

From a macro perspective, the default rates are important statistical measures if you are an economist. You can assess the overall condition of the economy by analysing the default rates.

Also Read: What to do in case you can't pay your EMI or loan amount due
 

Effects of Defaulting on Loans

You can face the following outcomes in case of a non-repayment of the loan amount:
 

1. Decrease in credit score

   A decrease in credit score will make it difficult for you to get loans in future.
    

1. Penalty

   Late payment or default payment may result in the imposition of some additional charges on your loan amount.
    

1. Legal proceeding

   The lender can file a case against you for default in payment. The terms and conditions of repayment may vary with different lenders and it entirely depends on the terms and conditions that the lender and you agreed upon.
    

1. Seizure of assets

   If you have borrowed a secured loan, your collateral may get seized and auctioned off.

 

Measures to Avoid Defaulting on Loan Repayment

There can be unpredictable situations due to which you may fail to pay your loan instalments on time. If it happens, you should:
 

1. Inform your lender

   Notify your lender about your problem at the earliest. You can discuss and work out a restructuring plan that will lower the burden on both of you. The lender can decide on a different payment schedule. It works for long-term loans. For short-term loans, you can sell off some assets to repay the debt. These loans have high interest rates.
    

1. Connect with HR Department

   Discuss with your employer or HR department any financial support programme in your organisation during an emergency.
    

1. Assistance from friends

   You can take the support of friends or family members for repayment of your ongoing loan. The amount that you borrow from them would be interest-free. Also, there would not be any strict deadline to pay back.
    

1. Avoid credit cards

   Limiting your credit card usage can help you avoid loan default by controlling your spending and reducing the amount of debt you accumulate. When you use your credit card for unnecessary expenses, such as dining out regularly, replacing gadgets every month, or shopping extravagantly, you can easily fall behind on your loan payments, resulting in a monthly penalty of around 3% on unpaid bills and a default-like situation.
    

1. Deferred payment

   Deferred payment options on a loan allow you to postpone making payments for a set period of time. You will not be required to make any payments during the deferred payment period, but interest will continue to accrue on your loan balance. As a result, it is critical that if you choose this strategy, you prepare a solid repayment plan.
    

1. Use Investment

   Investments can help you avoid a default-like situation by providing an additional source of income that you can use to make your loan payments. If you have a diversified investment portfolio that includes multiple assets such as stocks, bonds, and mutual funds, you may be generating annual income in the form of dividends and interest. This helps you keep up with your loan payments and avoid default. Additionally, having investments can provide a cushion of financial security that can help you weather unexpected expenses or financial setbacks. 
    

1. Windfall gains

   A windfall gain, such as an unexpected inheritance or a lottery win, can help you avoid default by providing a lump sum of money that you can use to pay off your loan balance or make your payments for an extended period. However, it is crucial to use the windfall gain wisely and prioritise paying off high-interest debt, such as credit card dues.
    

Also Read: How To Improve Your Credit Score After A Loan Settlement?
 

Conclusion

Non-repayment of a loan is a serious offence and can land you in trouble if repeated over some time. It can also affect your future borrowing capacity. To avoid these situations, try to pay your instalments on time or borrow an amount that you can comfortably payback

Disclaimer: This post was first published on 4th June 2021 and has been updated for the latest information, freshness and accuracy.