Default

What Is a Default?

A major concern for any financial institution that lends credit to others is the chance that the borrower will not pay them back. When this happens, and the borrower is financially unable to pay the lender back (or the contract has been breached another way), we call this defaulting.

Defaults are when customers take out loans from a bank or a private lender and fail to meet their contractual obligation. 

When banks or private lenders provide customers with credit, they allocate a period for the borrower to pay them back. 

The contract states that the lender and the borrower have other terms and conditions outside financial obligations. Therefore, a debt default also occurs if these terms are breached. 

Banks always try to calculate the risk of each customer to whom they lend. They can do this by looking at the customer's credit history, specifically their credit score. 

If the customer has a history of not paying their monthly payments, the lender may not choose the customer. 

When a default occurs, there are a lot of confusing terms that get thrown around. These terms often describe the situation from a legal perspective. These terms include:

• Delinquency - This occurs when a borrower misses or pays their interest payment late
• Illiquidity - This describes the situation where the borrower doesn’t have the assets to convert into enough money to meet their debt obligations. Illiquidity is often measured through financial ratios and metrics like the current and quick ratios
• Insolvency - A borrower cannot pay their debt obligations, likely leading to bankruptcy (see below)
• Bankruptcy - A legal term when the court recognizes that an entity is to pay its debt obligations and is insolvent

Understanding a Default

A common misconception is that defaulting means a missed/late payment. This would be categorized as a delinquent payment. Defaulting has to do with not following the contractual agreement made between the lender and borrower. 

There are two different types of debt defaults: Financial and Technical.

Financial are the ones where the party is financially unable to meet the terms of the contract. This is likely because the borrower doesn’t have the funds, leading to a delinquent payment.

The other form is a technical default. These include covenant breaches, changes in ownership, and breaches of important representations and warranties. 

Covenants breaches are when one party of the contract violates the contractual promises they made to the other party. There are two types of covenant breaches: affirmative and negative. 

Affirmative covenants mean that the contractual party must do these tasks to fulfill the contract. Negative covenants, however, mean that the contractual party must refrain from performing specific actions. 

Changes in ownership without telling the other party of the contract is a technical default too. Borrowers must inform their lenders about the change in ownership, and it must be agreed upon to have a legally binding contract intact. 

Lastly, breaches of important representations and warranties mean that one party didn’t fully know what they were getting themselves into. 

For example, there may have been some confusion, and one party believed that certain assumptions were true but later found out that they weren't.

It’s always important that when individuals take out loans, they read the contract and are satisfied with the terms and conditions. There should be no surprises when something wrong happens, and the contract says one thing, but you want another.

Defaulting on Secured Debt vs. Unsecured Debt

When a borrower breaks their agreement, the lender may seize the collateral or demand other financial compensation by suing the borrower. Financial compensation the lender gets widely depends on whether the debt was secured or unsecured.

Secured Debt

Secured debt is when some type of asset secures the loan. For example, the borrower will sign a contract saying that the lender will have access to this asset if they cannot make their debt obligations. This asset is something of value and is called collateral.

Using collateral reduces the risks placed on the lender. For example, if the borrower cannot make their debt obligations, the lender will collect the borrower's assets.

Using these assets (collateral), the lender can sell them and use the money from the sale to pay back the borrower's debt obligations. This way, the lender faces limited risks since they will get their money back one way or another. 

For example, mortgages on houses are very common forms of secured debt. In this instance, the borrower is taking out a loan (most likely from the bank) to purchase a house.

In these types of contracts, the property being purchased acts as a form of collateral. 

If the borrower cannot make their mortgage payments, the lender can collect and take control of the property. They can then choose to sell the property to get their money back.

Unsecured Debt

The other form of debt is when it is unsecured. This is when the lender has no legal claim to any of the borrower’s assets, even if the borrower doesn’t make their debt payments. 

This places a lot more risk on the lender since there is a chance that they completely lose the money that they provide the borrower. 

To make up for this, most unsecured lenders charge extremely high-interest rates on their debt. This makes unsecured debt very expensive for the borrower. 

However, if the borrower becomes insolvent, there is still a chance that the lender doesn’t lose money since they have accrued a lot from the interest payments.

Ways to Avoid Defaulting

Most of the time, lenders understand and are willing to work with you to ensure you meet your debt obligations. They understand that people go through financial hardships. Sometimes they will offer their borrowers relief to give them time to come up with the funds to make payments.

Relief forms like forbearance offer borrowers a temporary period without the debt obligation. This effectively puts the debt on pause. Borrowers collect their thoughts and try to come up with the money without the pressure of making the payments on time. 

There are even some situations where the government mandates these periods of temporary debt relief. For example, this was seen during the pandemic when the government enacted the CARES Act.

The CARES Act provided relief to millions of Americans due to the financial hardship caused by COVID-19 and the shutdown of the economy. In addition, THE CARES Act put a mandatory pause on student loans.

These loans were deferred until later to ensure people didn’t have to worry about making loan payments in times of crisis. 

Some people were lucky enough and had their entire loan balance canceled completely – fully alleviating them from the responsibility of the balance. 

As noted above, the two key forms of debt relief used are forbearance and deferment. Although these two terms seem similar, there is a key difference between them. 

While both effectively pause your monthly payments, forbearance will still accrue interest during this period. That means you’ll owe more money after the relief period than if you didn’t take the forbearance period. 

On the other hand, deferment offers an interest-free source of relief. This will offer borrowers the luxury of not owing any more money after the relief period than they already have beforehand.

What Happens When You Default on a Loan?

When looking at the consequences, it’s important to distinguish between personal and corporate/commercial borrowers. Personal borrowers are individuals taking out debt for themselves, while corporate borrowers are businesses that take out debt. 

While lenders are understanding and can be lenient, there will come a time when they need the money you owe them. This may force them to take legal action or other punitive measures to secure repayment. 

Sometimes even the government will get involved depending on the debt. For example, sometimes the government will withhold your tax returns and government social program benefits and may even use these to pay the outstanding debt. 

There is a huge range of potential penalties for borrowers who break their contracts and don’t pay. Sometimes borrowers can get off the light, and other times it can affect their life and financial health for years. 

It’s better to contact your lender if you experience financial hardships and try to negotiate an alternative repayment plan. See if there are any ways they can help you before you find out the consequences of breaking your contract.

Again, lenders will try their best to avoid taking legal action, as it can be time-consuming and costly for the lender to take the case to court. This is why they offer the different forms of debt relief listed above. 

Personal Borrowers 

The event is reported to the major credit bureaus when personal borrowers breach their debt obligations. This will impact the individual's credit score and credit history. 

This impact could make borrowing extremely difficult and force the borrower to take worse terms for taking out debt.

Once again, if the loan is secured, personal borrowers will also lose the asset they put up as collateral. This could be as big as losing a property or car. Forms of collateral usually have a lot of value, which could be a big financial loss for the borrower.

While unsecured loans may seem less risky, there are still financial risks for borrowers when defaulting on these loans. 

The personal borrower’s wages could get garnished. This would mean that a chunk of their paycheck is taken to pay the collection agency. 

Corporate/Commercial Borrowers

Banks or other lending institutions are generally more collaborative with corporate borrowers defaulting on debt. However, if the consequences are too extreme for the business, it could make the business fail. 

This would mean there would be no way for the business to pay the lender back eventually – which is the goal. Otherwise, the lender would have difficulty recouping the funds and tarnish their relationship with the borrower. 

Typically lenders approach it differently by taking various approaches to deal with corporate borrowers. Typically the consequences for corporate borrowers include:

• Requiring more frequent and detailed financial reporting to the lender. This would probably mean the reporting would occur monthly or quarterly.
• Requiring a detailed and structured plan of how the management will pay off the obligation. This would include a short-term, mid-term, and long-term plan. 
• Requiring the borrower to set up automatic payments and other mechanisms that control the borrower’s accounts to ensure payment.
• If problems continue between the borrower and the lender, the lender may transfer the case to its restructuring team. The restructuring team would provide even stricter guidelines and oversight over the company. 
• If the debt obligation seems not resolvable with the company's operations and cash flows, they may require the borrower to liquidate their assets to come up with the funds to make the payments.
• Bankruptcy is possible if the debt obligation becomes too much for the company to handle. However, this would allow the company to halt its operations and liquidate its assets without worrying about the lender – as these assets will be temporarily protected.

Researched and authored by Alexander McCoy | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Credit Analysis Basics
• Credit Analysis Report
• Credit Analyst Job
• Sovereign Debt
• Working Capital Loan