What happens when you default on a personal loan?

Understanding loan default

Your loan will be in default if you don't make a payment for 90 days. However, your loan will be considered delinquent as soon as your payment is late. Payments made between one and 30 days past the due date will be considered late. This may result in a late fee. If you don't pay after 30 days, your late payment will be reported to the credit bureaus, and your account will be considered delinquent, which will likely cause a drop in your credit score.

“The day after the due date of a loan, the loan becomes delinquent. Default, on the other hand, carries a more serious consequence. It comes after a period of sustained nonpayment, typically 90 to 180 days, depending on the lender’s policy,” Malloy explained.

If you continue not to make payments on the loan for 90 days, your account will go into default and collection efforts will begin. Once the late payment reaches 120 days, it's common for the lender to charge off the loan and sell it to a collection agency.

Consequences of defaulting on a personal loan

Consequences for late payments begin as soon as your payment is late, but the more delayed the payment, the greater the penalty.

The credit bureau will be notified as soon as your payment is 30 days late. Paying on time makes up 35% of your credit score. The later the payment is, the more damage it does to your credit score. Also, the more late payments that are reported to the credit bureaus, the lower your score will be.

Payment history is 35% of your total credit score.

Letting your loan go into default will have a major impact on your credit score. By the time your loan is in default, you already have several reported late payments. The late payments and the default will remain on your credit report for seven years, even if you later pay the loan off in full.

If the loan is secured, say with your vehicle, you will risk repossession of the asset. If you do not pay the loan based on the agreed-upon terms, the lender has the legal right to seize the asset and sell it in an attempt to collect the balance of the loan. Repossession will also negatively impact your credit.

Steps to take if you’re at risk of default

If you realize you will struggle to keep the terms of the loan, you should contact your lender right away. You may be able to renegotiate the terms of the loan to fit your budget more comfortably.

Malloy said: "As soon as you feel that you may miss a payment, you should contact your lender. Many of them have hardship programs, or they can provide you with altered payment plans. When you wait until a point that you’re in default, that really NARROWS your choices down a lot."

But you should still reach out, even if you've already missed some payments. "Be assertive — detail your circumstances, supply the evidence and request written confirmation of any new terms. Putting your head in the sand does not make this go away; lenders are much more agreeable if you are communicative than if you ignore them," said Malloy.

Debt consolidation vs. credit counseling

If the lender is unable to assist you, you may want to consider debt consolidation or credit counseling. Both are useful if you have several loans that you are having trouble paying.

With debt consolidation, you take out a new loan that combines some or all of your current debt into one new payment. The idea is to lower your total monthly payments to a level that you can maintain. It's important to do this before your credit begins to drop or you will have trouble getting a new loan.

Credit counseling may put you on a debt management plan with a payment that is lower than the combined amount of all your loans. You'll make a monthly payment to the credit counseling company, which will then distribute the funds to your loans. There are drawbacks to this plan, so make sure you understand the details before taking this route.

Legal implications of loan default

There can be legal implications for defaulting on a personal loan. "Once a personal loan goes into default, a lender has some legal options. For an unsecured loan — or a loan for which there is no collateral, such as a credit card debt or medical bill — lenders can sue the borrower in civil court for a judgment and, depending on the state, pursue wage garnishment or asset liens," Malloy told us.

If the lender sues you, don't ignore the court notices. It's best to respond by the date specified in the court documents. You may also want to get a lawyer to assist you.

Responding to the lawsuit gives you an opportunity to negotiate the debt or get it removed completely. Lenders need to prove that the debt is valid; if they are unable to do so, you will not be required to pay.

If you don't respond, it's likely the judge will issue a default judgment in favor of the lender. This gives the lender more tools to collect the debt from you, such as garnishing your wages or putting a lien on your property.

If you have an aggressive debt collection agency, you'll want to know your rights under the Fair Debt Collection Practices Act. For example, debt collectors are not allowed to call you before 8 a.m. or after 9 p.m. or at a place they know is inconvenient, such as your workplace. If you get an attorney, they are not allowed to contact you at all and all communication must go through your attorney.

Recovering from a loan default

If you currently have a loan in default, contact your lender and see if there are any remedies available. You may be able to negotiate a settlement, where you make a lump-sum payment for less than the amount owed.

If your credit hasn't been damaged too much, you could consider refinancing the loan or getting a debt consolidation loan. If none of that is an option, you may want to speak with a credit counselor to see about getting on a debt management plan.

When the time is right, you can begin to rebuild your credit by making on-time payments on other debts and keeping the total amount borrowed low. You may need to start with a secured credit card and build from there.

Your payment history is 35% of your total credit score, so it's important to start paying all your other debts on time. How much you owe is 30% of your credit score, so try to keep your balances low. You should aim to keep the balance on revolving debt, like credit cards, below 30% of the credit limit.

» TIPS: 9 ways to improve your credit score