Default: What It Means, What Happens When You Default, and Examples

What Is a Default?

Default is the failure to make required interest or principal repayments on a debt, whether that debt is a loan or a security. Individuals, businesses, and even countries can default on their debt obligations. Default risk is an important consideration for creditors.

Key Takeaways

  • A default occurs when a borrower stops making required payments on a debt.
  • Defaults can occur on secured debt, such as a mortgage loan secured by a house, or on unsecured debt, such as credit cards or student loans.
  • Defaults expose borrowers to legal claims and may limit their future access to credit opportunities.
  • Borrowers can avoid defaults by working with lenders, modifying their debt, or trying to secure better loan terms.
Default

Investopedia / NoNo Flores

Understanding a Default

A default can occur on secured debt, such as a mortgage loan secured by a house or a business loan that's secured by a company's assets. The loan could go into default if the borrower fails to make timely payments and the asset or collateral that was used to secure it would be in jeopardy. A company that's unable to make required coupon payments on its bonds would also be in default.

Defaults can occur on unsecured debt as well, such as credit card balances. A default reduces the borrower's credit score and can limit their ability to borrow in the future.

Defaulting on Secured Debt vs. Unsecured Debt

Its lenders or investors may sue to recover the funds when an individual, business, or country defaults on a debt. Their recovery prospects will depend in part on whether the debt is secured or unsecured.

Secured Debt

The bank may ultimately foreclose on a home that secures a mortgage if the borrower defaults on the mortgage. The lender can repossess the vehicle if a borrower defaults on an auto loan. These are examples of secured loans. The lender has a legal claim to a particular asset that's acquired with a secured loan.

Corporations in default on secured debt may file for bankruptcy protection to avoid forfeiture, providing time for negotiations on a settlement with creditors.

Unsecured Debt

A default can also occur on unsecured debt, such as medical bills and credit card balances. Unsecured debt isn't backed by an asset but the lender still has a legal claim in the event of a default. Credit card companies often wait a few months before sending an account into default.

The debt would be "charged off" after six or more months without payments being made on an outstanding balance. The lender would write it off as a loss and close the account on a debt that's been charged off. The creditor may then sell the charged-off debt to a collection agency, which would then attempt to collect from the borrower.

A collection agency that buys a charged-off, unsecured debt can have a lien or judgment placed against the borrower's assets. A judgment lien is a court ruling that gives creditors the right to take possession of a debtor's property if the debtor fails to fulfill contractual obligations.

3 Types of Defaults

There are technically three different legal types of delays or defaults in contractual or legal obligations, particularly in civil law systems.

  1. Mora solvendi is also called "debtor's default". This refers to a default on the part of the debtor or obligor - the party who owes a duty or obligation. It's further divided into two subcategories: One category relates to defaults in obligations to give or deliver something specific. For example, if a seller fails to deliver goods on the agreed date, this would be considered a debtor's default. The other category occurs in obligations that require personal performance or action. For instance, if a contractor fails to complete a service by the agreed deadline, this would also be a debtor's default.
  2. Mora accipiendi is also called creditor's default. This refers to a default on the part of the creditor or obligee - the party to whom an obligation is owed. This occurs when the creditor fails to accept performance or payment when it's properly offered by the debtor. For example, if a buyer refuses to accept delivery of goods that meet the contract specifications, this would be mora accipiendi.
  3. Last, compensatio morae is also referred to as mutual default. This refers to a situation where both the debtor and creditor are in default in reciprocal obligations. For instance, in a sale contract, if the seller fails to deliver the goods and the buyer fails to pay the price, both at the same time, this would be compensatio morae.

These concepts are important in determining liability and remedies in contractual disputes. In civic law cases, these three determine which party is at fault, to what degree, and what consequences should follow.

General Implications of Defaulting

Very broadly speaking, there's a handful of things that could happen if you default on a loan. The following list depends not only on the type of loan you're defaulting on but your credit history, net worth, liquid assets, and legal standing with your loan contract. We'll look at more specific outcomes of defaulting on specific types of debt later.

  • Credit Score Damage: Defaulting on debt could severely impact your credit score. Late payments and defaults are reported to credit bureaus and can remain on your credit report for up to seven years. This lower score makes it difficult to obtain new credit or loans and can result in higher interest rates on future borrowing.
  • Legal Action: Creditors may sue you to recover the debt. If they win, they can obtain a judgment against you which may lead to wage garnishment, bank account levies, or property liens.
  • Collection Activities: Your debt may be sold to a collection agency. These agencies can be aggressive in their pursuit of payment, often making frequent calls and sending letters.
  • Asset Seizure: For secured debts like mortgages or car loans, the lender may repossess the asset. This means you could lose your home to foreclosure or your vehicle to repossession.
  • Employment Difficulties: Some employers check credit reports as part of their hiring process. A default on your credit report could potentially impact your job prospects, especially in fields like finance or those requiring security clearances.
  • Housing Challenges: Landlords often check credit reports when evaluating rental applications. A default can make it harder to rent an apartment or house or may require you to pay larger security deposits. The same can be said for mortgages which require substantiation of good financial standing before a home loan can be secured.
  • Higher Insurance Premiums: In some states, insurance companies use credit-based insurance scores to determine premiums. A default can lead to higher rates for auto, home, or other types of insurance.
  • Difficulty Opening Bank Accounts: Some banks use ChexSystems or similar services to screen applicants for new accounts. A history of defaulted debts can make it challenging to open new bank accounts.
  • Tax Consequences: If a debt is forgiven or canceled, the forgiven amount may be considered taxable income by the IRS. This can result in an unexpected tax bill, further perpetuating financial strife.

Defaulting on a Student Loan

Student loans are another type of unsecured debt. Defaulting on a student loan has the same consequences as failing to pay off a credit card, affecting your credit score, your credit rating, and your future loan prospects. Those who default on federal student loans may also face wage garnishment.

First You’re "Delinquent"

Your loan is officially delinquent when your payment is 90 days overdue. It's reported to all three major credit bureaus so your credit rating will fall. New credit applications may be denied or approved only at a higher interest rate that can be charged to riskier borrowers.

A bad credit rating can follow you in other ways. Potential employers and potential landlords often check the credit scores of applicants, especially employees who will need a security clearance to perform the job.

Next, You’re "in Default"

The loan will end up in default if your payment is at least 270 days late. About one third of all federal student loan borrowers have been in default at some point.

Borrowers who don't enter a loan rehabilitation agreement with Default Resolution Group at the department's Office of Federal Student Aid can eventually be subject to withholdings of tax refunds and other federal payments, as well as garnishments of up to 15% of their take-home pay.

You can enter the federal student loan rehabilitation program or use loan consolidation if your federal student loans are in default.

Deferment or Forbearance

A good first step is to contact your lender as soon as you realize that you may have trouble keeping up with your payments. The lender may be able to work with you on a more attainable repayment plan or help you obtain deferment or forbearance on your loan payments.

Temporary Aid for Student Loan Borrowers

Student loan payments and the accumulation of interest on outstanding loans were suspended by the Department of Education (DOE) as a COVID-19 relief measure. The DOE then extended the pause on federal student loan payments in November 2022 in response to a federal court order blocking the White House’s student loan forgiveness plan.

Student loan payments were scheduled to resume 60 days after the department was permitted to implement the program or the litigation was resolved. Student loan interest charges then resumed on Sept. 1, 2023 and payments restarted in October 2023.

Sovereign Default

Sovereign default occurs when a country doesn't repay its debts. A country that's in default usually cannot be compelled to satisfy its obligations by a court, unlike an individual or corporate debtor. But it does face a variety of other risks and problems. The economy might go into recession or the currency might devalue. The defaulting country may be shut out of debt markets for years to come.

Sovereign default can occur for a variety of reasons, including political unrest, economic mismanagement, or a banking crisis. Greece defaulted on a $1.73 billion payment to the International Monetary Fund (IMF) in 2015 before securing additional debt relief from the European Union.

Fitch, a leading provider of credit ratings, downgraded the U.S. credit rating from AAA to AA+ on Aug. 1, 2023. It indicated that it foresees "fiscal deterioration" over the next three years and cited the federal government's tendency for last-minute negotiations over the country's debt ceiling. The U.S. Budget Committee has indicated that this is only the second time in the nation's history that a credit rating provider has taken this action.

Defaulting on a Futures Contract

Defaulting on a futures contract occurs when one party doesn't fulfill the obligations set forth by the agreement. Default usually involves a failure to settle the contract by the required date in this case.

A futures contract is a legal agreement for a future transaction involving a particular commodity or asset. One party to the contract agrees to buy at a specific date and price and the other party agrees to sell at the contract-specified milestones. They could face collections actions and lawsuits if one party defaults.

A default will stay on your credit reports and be factored into your credit score for seven years, according to the credit bureau Experian.

What Happens When You Default on a Loan?

If you can't make your loan payment, that doesn't necessarily mean you have to default. There's a handful of options and alternatives you might be able to secure:

  • Loan Modification: A loan modification involves working with your lender to change the terms of your existing loan. This could include extending the loan term, reducing the interest rate, or even forgiving a portion of the principal. The goal is to make your monthly payments more manageable based on your current financial situation. You may still be on the hook for the same amount of debt, but the modification makes it so your payments are smaller for longer.
  • Debt Consolidation: Debt consolidation involves taking out a new loan to pay off multiple existing debts. This new loan typically has a lower interest rate than your current debts, potentially reducing your monthly payments and making them easier to manage. This option works best for those with good credit who qualify for lower interest rates.
  • Refinancing: Similarly, refinancing involves replacing your current loan with a new one, often with better terms. This could mean a lower interest rate, a longer repayment period, or both, resulting in lower monthly payments.
  • Forbearance: Forbearance is a temporary postponement or reduction of loan payments granted by the lender. This option is often used during short-term financial hardships, such as job loss or medical emergencies. During forbearance, interest typically continues to accrue, and you'll need to repay the missed amounts later, either in a lump sum or by adding them to future payments. Still, it could act as a temporary aid until you're able to make payments again.
  • Credit Counseling: Credit counseling involves working with a financial professional who can review your financial situation, help you create a budget, and provide advice on managing your debts. If it appears you may be headed towards a default, a creditor may require you to do counseling in exchange for more favorable debt terms.
  • Selling Assets: If you have valuable assets, selling them to pay off your debt can be a way to avoid default. This could involve selling a car, jewelry, investments, or other high-value items.

Real-World Example

Bed Bath & Beyond, once a major retail chain in the United States specializing in home goods, filed for Chapter 11 bankruptcy protection on April 23, 2023. This filing came after years of declining sales, mismanagement, and failed turnaround attempts.

The company had been struggling for several years, facing intense competition from online retailers like Amazon and other big-box stores. The COVID-19 pandemic further exacerbated its problems, as it did for many brick-and-mortar retailers.

In the lead-up to its bankruptcy filing, Bed Bath & Beyond defaulted on a significant portion of its debt. In January 2023, the company warned that it was considering filing for bankruptcy protection due to its inability to repay its outstanding loans. At the time of its bankruptcy filing, the company listed its assets at $4.4 billion and liabilities at $5.2 billion. Thus, the company did not have enough assets on hand to pay its debt and therefore defaulted on loans.

What Happens When You Default on a Payment?

Your account is ultimately sent to a debt collection agency that tries to recover your outstanding payments when you default on a loan. Defaulting on any payment will reduce your credit score, impair your ability to borrow money in the future, lead to charged fees, and possibly result in the seizure of your personal property.

How Long Does a Default Stay on Your Credit Report?

Defaults stay on your credit report for seven years. A default may be removed earlier if it can be proven that it was a mistake. Your credit score should improve after the default is removed.

What Is an Example of a Default?

A default is a missed payment or multiple missed payments on money that you've borrowed. An example of a default would be not paying your credit card bill or your monthly mortgage payment.

The Bottom Line

Default is the failure to make required interest or principal repayments on debt. Individuals, businesses, and countries can default on debt obligations. Failure to meet payments on a mortgage, student loan, or personal loan will affect an individual's credit rating, their ability to secure future loans, and could result in the seizure of property or wages.

Corporations can default by failing to meet coupon payments on bonds. Sovereign default occurs when a country doesn't repay its debts.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. National Credit Union Administration. "Personal Loans: Secured vs. Unsecured."

  2. United States Courts. "Chapter 11-Bankrupty Basics."

  3. Federal Register. "Credit Card Penalty Fees (Regulation Z)."

  4. Experian. "What Does “Charge off” Mean on a Credit Report."

  5. Consumer Financial Protection Bureau. "What is a Judgment?"

  6. Federal Student Aid. “Student Loan Delinquency and Default.”

  7. The Pew Charitable Trusts. "Government Hits Reset on Student Loan Defaults, But Many Could Experience Default Again."

  8. Federal Student Aid. "Collections on Defaulted Loans."

  9. Federal Student Aid. "Getting Out of Default."

  10. U.S. Department of Education. "Biden-Harris Administration Continues Fight for Student Debt Relief for Millions of Borrowers, Extends Student Loan Repayment Pause."

  11. Federal Student Aid. "COVID-19 Emergency Relief and Federal Student Aid."

  12. The Wall Street Journal. "Greece to Default on $1.73 Billion IMF Payment."

  13. Fitch Ratings. "Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable."

  14. U.S. Budget Committee. "U.S. Debt Credit Rating Downgraded, Only Second Time In Nation’s History."

  15. Experian. "How Does Default Impact Your Credit?"

  16. Kroll Restructuring. "Bed Bath & Beyond Inc."

  17. United States Bankruptcy Court District of New Jersey. "Bed Bath & Beyond, Inc."

Open a New Bank Account
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.