A default is when an individual stops making payments on a debt. If the debt is secured, such as a mortgage or an auto loan, the lender can repossess the asset that was acquired with the loan. If the debt is unsecured, such as a credit card balance, the lender can sell the debt to a collections agency who will attempt to collect the owned funds and, if necessary, seek a court ruling that gives them the right to take possession of the borrower’s assets.
In addition to these direct consequences, defaulting on a debt can have indirect long-term consequences for your financial future. Here are three ways a default could impact your financial health.
Defaults reduce your credit score
Your credit score is a numerical representation of your trustworthiness when it comes to repaying debt. It is calculated from your credit report, which records all lines of credit you currently have open or have had open in recent years.
If you repay debts in a timely manner, your credit score is likely to be Very Good or Excellent which indicates to lenders that you’re a safe person to lend to. If you make late payments or default on a debt, your credit score will fall to Fair or Poor, and lenders will consider you a risky person to lend to. According to the FICO credit scoring method, credit scores are labeled as follows:
- Excellent: 800–850
- Very Good: 740–799
- Good: 670–739
- Fair: 580–669
- Poor: 300–579
It can be harder to secure lines of credit when you have a Poor credit score, which means you may have less financial freedom after defaulting on a loan. You might have trouble getting a mortgage, credit cards, and personal loans with a default on your record.
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Defaults lead to higher interest rates
In instances where you can find a lender willing to offer you a loan with a default on your record, you can expect the interest rates on that loan to be much higher than without a default.
The risk of lending to a previously defaulted borrower is high, and the lender expects a high return on their investment as compensation for shouldering that risk. In 2023, median available credit card APRs started at 19.37% for those with Good credit scores, and 24.62% for those with Fair credit scores.
Defaults stay on your file for up to 7 years
Late, missed, and defaulted debt repayments can stay on your credit file for up to 7 years, after which point the statute of limitations expires and they must be removed from your credit record. Your credit score, your ability to get credit, and the interest rates offered to you will be affected for as long as the default remains on your record.
You can minimize the impact of a default on your credit score by bolstering your credit score in other ways, such as making payments on time, maintaining a mix of credit types, and avoiding applying for new lines of credit on a regular basis.
Avoid defaults to protect your financial health
Defaulting on a loan is one of the most serious ways you can damage your financial health, so be sure to adhere to debt payment plans. If you find yourself struggling to pay, call your lender to discuss your circumstances and negotiate a temporary reduction in payments.
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