Default (Non-Payment) - Explained
What is a Default?
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Table of ContentsWhat is a Default?How does a Default Work?Default on Secured DebtDefault on an Unsecured DebtDefault on a Student LoanDefaulting on a Futures ContractSovereign DefaultConsequences of DefaultReal World Examples of Default
What is a Default?
A "default" refers to the non-payment or non-remittance of loan or debt that is formally agreed on. It is the failure of a party to repay the principal or interest payments on a loan or security which was formerly agreed upon in the loan contract. Different situations in a loan arrangement can be tagged as default. For instance, failure to continue repaying a loan, inability of a borrower to make a payment on time or if the borrower misses payments, default has occurred.
How does a Default Work?
Generally, the failure or inability of a borrower to fulfill loan obligations or terms of a contract is a default. When an individual takes a business loan or mortgage loan in which the terms of repayment are agreed in a legal contract, and the borrower fails to meet the terms of the contract, a default has occurred. In cases of mortgage loans, failure to make mortgage payments at agreed time is default. In bonds, failure to make coupon payments to bondholders is also a default on the bonds.
Default on Secured Debt
Auto loans and mortgage loans are examples of secured debts. Borrowers of secured debts can also default on payments and loan obligations. However, in secured debts, a collateral is required to finance the debt in case the borrower defaults in the future. In auto and mortgage loans, the item being financed is made the collateral in the event of default by the borrower. For example, a mortgage bank can reclaim or sell the home for which the borrower secured the loan if the borrower fails to make principal and interest payments on the loan. A lender can also use the automobile it financed with an auto loan if the borrower defaults. A borrower that is default seeks protection by filing for bankruptcy protection under the United States bankruptcy Code. this protection allow lenders and borrowers reach an agreement on repayment of the debt.
Default on an Unsecured Debt
An unsecured debt is a type issued to a borrower without any collateral. Common examples of unsecured loans are medical bills, utility bills, credit card debt and other forms of loans that require no collateral. Borrowers of unsecured debts also have the tendency of defaulting on the loan agreement or repayment of the debt. If an individual defaults on unsecured loans, a grace period is usually allocated to the borrower. For example, Credit card companies can give a grace of six months before the account goes into default. A period of 30 to 60 days is the common duration given as grace period for defaults on an unsecured loan. After this period elapses, a lien might be placed on the borrower's assets until the debt obligation is fulfilled.
Default on a Student Loan
Just like other forms of unsecured debts, student loans require no collateral before the debt is issued to students. Defaulting on a loan of the nature is a bad idea that every student must avoid, it attracts grave consequences. Due to the fact that most student loans are guaranteed by the federal government, ignoring repayment of the debt is not a good idea. A delinquent is a legal term that describes a wrongdoer or a lawbreaker, usually a young person.. An individual or a borrower becomes officially delinquent if a debt payment is due for over 90 days. Ordinarily, the term 'delinquent' describes the tendency of an individual to commit a minor crime. Hence, if a borrower enters a state of delinquency, it indicates the tendency of entering a state of default, although, this is not so in all cases. Once a borrower becomes delinquent, the three major credit bureaus will be notified, this will give the individual a bad credit rating meaning applications for new credits will be automatically disapproved. Oftentimes, employers gauge the characters of potential employees by checking their credit rating. A borrower enters a default state when payment on loan or a debt contract is 270 days late. Once a payment is in default, the lender reports the default to a collection agency. A collection agency has the responsibility of stirring default borrowers to make payments on the existing loan. However, after several attempts by a collection agency to make a borrower pay, the federal government might intervene. Once the federal government is involved in the case, certain measures can be taken to rectify payments into the existing debt. For instance, the borrower's employer might be required to set aside a portion of the salary which will be directed towards loan repayment. There are better alternatives a borrower can employ rather than entering a state of default. Mostly importantly, a borrower sensing that there is a tendency of the loan going into default must inform the lender. Ensure that you alert your lender and keep your financial institution abreast of the troubles you are experiencing pertaining to loan repayment. One of the alternatives to default is to have a workable plan with the lender or financial institution on a flexible repayment schedule if the borrower has problems fulfilling the initial schedule.
Defaulting on a Futures Contract
In a futures contract, the two parties involved (the buyer and the seller) agree to buy and sell a particular quantity of asset at a predetermined price and at a specified date later in the future. In this trade arrangement, default can occur. This means either of the parties might fail to fulfill the terms of the contract or one party fails to settle the deal at the predetermined price. As a type of forward contract, the terms and obligations of futures contract are legally binding on both parties, therefore, default can be legally resolved.
Sovereign defaults occur at the national level. It is when a country or government of a nation fails to meet financial obligations on debts or bonds or issued. Usually, government raise funds for capital project through the sales of bonds and other low-risk investment instruments backed by the government A sovereign default occurs when obligations on government bonds and debts are not met. Different factors are responsible for sovereign defaults, common examples are overspending by the government of a country, too much debts leading to heavy weight on the government, decline in tourism and many other factors. Jamaica and Greece are examples of countries with sovereign default in 2010 and 2015 respectively.
Consequences of Default
A borrower can default, so also a bond issuer. There are certain consequences of default and they have varying degrees. The following are the consequences of a borrower's default on a loan repayment;
- Reduced or zero chance of securing credit later in the future.
- A dent on the borrower's credit rating, a default borrower would have a bad credit rating.
- Deprivation of well-paying jobs because many employers check the credit rating of employees before recruiting them.
- Higher interest rates on new debts and old (existing) debts.
- Deduction of salary for loan repayment purpose or garnishment of wages.
When there is a default on the part of a bond issuer, it indicates that the company has poor management. Here are the consequences of bond issuers default;
- Poor credit rating.
- A decline in the creditworthiness of the bond issuer.
- A decline in the rate of investors due to poor credit rating.
- Problems with raising funds to finance business operations.
- A negative imprint on the bond issuer's image even for future trades and business transactions.
Real World Examples of Default
In the history of the United States, Long-Term Capital Management, a large hedge fund is an example of a company that defaulted and eventually went bankrupt in 2000. In 2010, a sovereign default occurred when Jamaica defaulted on government bonds and debts worth $7.9 billion. Another instance of default on bond payment is the case of Puerto Rico that defaulted on a $58 million bond payment in 2015, according to a report by CNN, only $628,000 was paid. Greece in 2015 also defaulted on a payment to IMF. Here are some important points to note about default:
- Failure or inability to make principal and interest payments on a secured loan is a default.
- Delay in making payments, avoidance of payments and cessation of necessary payments by a borrower is a default.
- Failure to fulfil or meet the terms of a debt contract is a default.
- Secured debts and unsecured debts arrangements can experience the occurrence of defaults.
- There are certain aftermaths attributed to defaults, they include; low credit ratings of the borrower, higher interests on debts, the borrower might be deprived of securing loans in the future.