The 4 Types of Loan Defaults

A loan default will usually be categorized as a debt service default, a technical default, a sovereign default or a strategic default. Defaulting on a loan means a borrower has not fulfilled the conditions in repayment of a debt. For each default the consequences will vary for non-payment of the loan.   

Debt Service Default

A debt service default is missing a scheduled payment on a loan. A borrower’s inability to pay a loan will not keep it from going into default status. Delinquencies on a scheduled loan payment are reported to credit agencies usually after 60 days late. Once a loan goes into default status, the principal plus interest must be paid in full. A lender has several options for obtaining the money which includes garnishing wages, seizing the funds from a bank account, or withholding the money from annual tax refunds.

Technical Default

A technical default is the result of not meeting a condition of the loan, and has nothing to do with missing a scheduled loan payment. Business loans contain affirmative and negative covenants. An affirmative convenant is an agreement to something. Negative covenants are the opposite, they restrict a business from doing something.  These requirements and restrictions are put in place to protect the both the lender and the business. Affirmative convenants include maintaining taxes and certain levels of insurance. Negative convenants may restrict a business from disposing of any assets or changing the nature of their business. A technical default will also result in payment to be made in full. 

Sovereign Default

Countries can default on debt, however, since they are not subject to any bankruptcy court, usually no legal consequences will be taken. Even though a nation will not likely be held to any legal action, it is in their best interest to honor the debt re-payment, because they will likely lose access to international lending in the future. If they are extended credit, the cost to borrow from a foreign lender will increase since they will be charged more. When a nation is on the brink of loan default, the creditor will work with the nation to restructure the loan. The loan term may be extended and the re-payments may be reduced.

Strategic Default

A strategic default is when a borrower purposely refuses to make a payment on a loan despite their ability to make the payments. This will usually occur with a non-recourse loan. Unlike a student or auto loan, with a non-recourse loan the creditor cannot go after the borrower’s assets if they decide to default on the loan. A mortgage loan is an example of a non-recourse loan a borrower will strategically default. If a borrower’s home value has decreased to the point where they owe more on the property than what it is worth, a borrower may decide to walk away from the home. The lender’s only recourse is to take possession of the property.

Any of these loan defaults can have a lasting impact on a borrower’s credit rating and greatly limit the borrower’s ability to obtain another loan in the future. A lender may decide to risk lending to the borrower, however, at a much higher interest rate than a borrower who is creditworthy.

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