With surging numbers of Coronavirus cases worldwide, more and more people are being furloughed, laid off or asked to take paid leave with no guarantee of job stability. Increasingly, people worldwide are wondering what happens if you default on a loan because you don’t have the cash flow to pay it?
There are six possible outcomes, as described below. If you are tight on money and are defaulting on a loan, you’re not alone.
In fact, around one million people will default on their student loans this year alone, along with all of those who are defaulting on their mortgages. With the Coronavirus pandemic affecting economies worldwide, loan defaults could reach unprecedented new highs.
How to Prevent Defaulting on a Loan
The best solution is to take steps to avoid defaulting in the first place. There are four primary strategies that you can use to avoid a defaulting on a loan, which are:
- Work with Your Lender: You can ask your lender for reduced payments during a time of hardship.
- Refinance: You could seek a refinance of your loan terms in order to lower your loan payments, usually by extending your payments over a longer period of time.
- Increase Income: You could increase your income, so you’ll have more money available to make payments. This is doable and realistic if you explore your options and commit to it.
- Reduce Expenses: You could substantially reduce your expenses, which you could do by downsizing to a smaller house/apartment, moving in with parents or friends or selling a vehicle.
Unfortunately, even with this checklist, sometimes things happen where you run out of options and get in so over your head in bills that a default is inevitable. In that case, knowing what to expect can help you prepare for the consequences.
6 Consequences of Defaulting on a Loan
What happens when you default on a loan? There are six common outcomes that range in severity from insignificant to severe, including:
- You’ll Incur Fees and Higher Interest
- Your Credit Score will Drop
- You’ll Be Sent to Collections
- Your Wages Could be Garnished
- Your Assets Could Be Seized
- You May Have to File for Bankruptcy
Each of these options is explained in more detail below, in order from the least severe to the most severe.
1. You’ll Incur Fees and Higher Interest
If you’ve only missed your loan payment by less than 30 days, you might have a grace period where you don’t face any financial consequences. But any later than that, and your lender can hit you with additional fees and possibly higher interest charges.
For example, you might have trouble paying your mortgage and miss your payment by 45 days. Your lender can hit you with a late fee that’s a percentage of your mortgage payment.
Another issue that can happen is the interest will compound on the missed payment amount while it’s late. This means more in interest for you in the long run.
2. Your Credit Will Take a Hit
One missed loan payment is enough to hurt your credit and lower your score.
The credit reporting agency Equifax estimates that people with very good credit scores could see up to a 110-point drop from a single default.
Further drops occur with each defaulted payment.
And, once you’ve been in default for more than 30 days, the problem shows up on your credit report for any potential creditor to see. This means you can have more trouble down the road when you want to apply for a car loan or mortgage. It might also trigger other creditors to close your accounts or reduce your credit limits.
3. Your Account Can Get Sent to Collections
Along with the additional costs and credit impact of a loan default, you can also expect to deal with the creditors. They might call you several times a day at home or work to nag you about the loan default. They might also send you letters demanding payment or threatening legal action.
The lender can also send your account to a collections agency once you’ve been in default for around 90 to 180 days.
This can mean more calls and letters along with additional financial consequences. The agencies can be even more aggressive in their demands for payment.
The collections agency usually also charges a fee beyond what you owe, so this means more expenses for you. The account will also now show up on your credit report as one that’s with a collection agency. This comes with additional hits to your credit score and may make it even harder to get credit in the future.
You also run the risk that the collection agency sues you for your debt.
This means you might receive a letter that you need to appear in court or accept an unfavorable repayment plan the collection agency offers you. If you fail to pay or show up in court, then you can face further consequences.
4. You Could Have Your Wages Garnished
Wage garnishment usually happens when you fail to pay back a collections account or present yourself in court when requested.
This means that the creditor can get legal permission to take a portion of your pay until you’ve fully paid off that defaulted debt.
This amount varies by state but may be a set percentage like 25% of your net paycheck. This can make it hard to pay your rent, utilities, or food bills.
You may be able to get an exemption from wage garnishment so that some of your income is excluded. For example, any Social Security, child support, disability, or alimony income is usually safe. But you can still expect your earned income to be impacted.
5. You Could Have an Asset Seized
If you default on a loan backed by a physical asset like your car or a piece of real estate, then you risk having the creditor take the item away from you if you default.
Repossession usually happens after several months of default.
You should have gotten notices and information about your options beforehand. Repossession usually doesn’t come without a warning.
Even if the creditor repossesses the item, you might still find yourself liable for additional money if the sale of that asset can’t pay off your defaulted loan. If you find yourself in danger of repossession, contact your creditor to see how you can make up payments to avoid the trouble.
6. You May End Up Needing to File for Bankruptcy
If you’ve defaulted on a loan and have no remaining means to pay it back, then you can consider filing for bankruptcy. Depending on the type of bankruptcy you file, the debts may be permanently wiped, or you may need to agree to an affordable repayment plan for a number of years.
The process requires court visits and comes with a lot of paperwork and documentation. In some cases, you may have to give up valuable assets as part of the agreement.
Keep in mind that current law means that bankruptcy won’t help you get rid of government-backed student loans.
If student loan debt is the problem, you’ll need to work it out directly with your loan servicer.
Now You Know What Happens When You Default on a Loan
Knowing what happens when you default on a loan can encourage you to take action to better manage your finances. Setting a budget, monitoring your loans, and avoiding taking on new credit can help.
Even if you’ve already defaulted and have dealt with some of these effects, it still may not be too late. Contact your lender as soon as possible so that you can arrange a more affordable payment.
If you’re in collections, don’t ignore those calls or letters.
My goal is to teach you how to go back on financial “offense,” something you probably weren’t taught by your parents and teachers, because they didn’t know it themselves.
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