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What is Loan Default and What Happens After You Default?
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What is Loan Default and What Happens After You Default?

Loans can be an important tool for turning your dreams into reality. Whether purchasing a home, starting a business, funding education, or buying a car, loans provide the financial means to achieve various far-reaching goals. But with the privilege of borrowing comes the responsibility of repayment and adhering to your loan contract.

Unfortunately, not all borrowers can fulfill their obligations, and this can lead to a consequential scenario known as "loan default."

No one borrows money to default. But life often happens, and you might find yourself in a position where you can’t make your monthly debt repayments. This is why, whether you have already borrowed or are planning to borrow, understanding loan default, its implications, and how to avoid it is a helpful and vital part of responsible borrowing. 

Read Also: 8 Things You Must Not Overlook While Applying for a Loan

What is Loan Default and How it Works 

An event of default occurs when you violate/breach one (or more) terms of your loan agreement.

When a lender provides credit to a borrower, they agree to loan terms through a legally binding loan contract. This loan contract typically includes a section defining what constitutes a debt default and what right(s) the creditor has to remedy the default. 

The most straightforward example of loan default is when a borrower fails to make timely payments. This could include missing one or more installment payments. Before you default on the loan, most lenders have a grace period called delinquency. It is the period between missing a payment and officially defaulting on the loan. 

The length of the delinquency period will vary based on your loan, but it kicks off as soon as you're late with your payment. Depending on your loan type, lender, and credit contract, this grace period can range from 30 to 90 days. Some lenders do not offer a delinquency period.  

Other examples that can lead to default, include: 

Violation of Loan Covenants: These could include requirements such as maintaining the collateral, meeting financial ratios such as DTI, updating insurance requirements, reporting obligations, or other conditions. If the borrower breaches any of these covenants, e.g., loses their collateral, it may lead to a default. 

Fraudulent Activities: If it comes to light that the borrower engaged in fraudulent activities during the loan application process or misrepresented information that influenced the lender's decision to approve the loan, it may lead to default. 

Bankruptcy: If the borrower files for bankruptcy, it can trigger a default on the loan. In some cases, the lender may have specific clauses related to bankruptcy in the loan agreement.

Misusing The Funds: This might include using the loan funds for purposes not approved by the lender. 

It's important to note that the list above is not exhaustive. Different lenders may have different default clauses, and the terms can vary between loans such as mortgages, personal loans, and business loans. Therefore, take time to understand your loan agreement's specific terms, conditions, and potential consequences of default. 

What Causes Loan Default?

Defaulting on a loan can happen for various reasons, and it's important to be aware of potential factors that may lead to such a situation as they're keys to finding a solution and taking measures to protect yourself. Here are some common causes of loan default: 

Financial Hardship: Unexpected financial challenges such as job loss, salary reductions, medical emergencies, or other unforeseen expenses can make it difficult to meet loan obligations.

Excessive Debt: If you take multiple other debts and increase your debt-to-income ratio, managing repayments can become overwhelming, leading to difficulty meeting loan obligations.

Interest Rate Increases: For variable-rate loans, an increase in interest rates can result in higher monthly payments, making it harder for you to afford repayments.

Insufficient Planning: Poor financial planning or budgeting can contribute to default. Failing to allocate funds appropriately or living beyond one's means may lead to financial strain.

Major Life Events: Events such as divorce or separation, the birth of a child, the death of a spouse/family member, your death, etc., can have financial implications, affecting income and expenses and making it challenging to meet loan obligations. 

Legal Issues: Legal troubles, such as lawsuits that threaten the collateral or bankruptcy, can impact your financial situation and lead to loan default.

Asset Depreciation: If a loan is secured by an asset, a decrease in the asset's value can affect your ability to fulfill the loan requirements, and that can trigger a default. For example, if you take an Uber Car Loan and get involved in an accident, the car value will drop, and you may have negative equity. In such a case, lenders might demand early repayment. 

Read Also: How to Avoid Regret After Taking Out a Loan

Consequences: What Happens When You Default?

When your loan goes into default, you will start receiving calls from your lender reminding you of your obligations and the consequences of not upholding them. 

If you don't reach an agreement soon, the creditor may appoint a third-party debt collection agency to persuade you to repay the loan, and if that fails, take action on behalf of the lender to recover the money. Recollections are often done at your cost. 

Defaulting on a loan can have serious consequences, and the specific outcomes can vary based on the type of loan and your credit contract. 

However, defaulting on any loan will likely result in a significant negative impact on your credit score. A lower credit score can affect your ability to secure future loans and may result in higher interest rates. Additionally, you may be charged late payment penalties that can increase your debt burden.

If you default on an unsecured personal or business loan, the lender will likely list you negatively on CRB, and depending on your agreement, they might initiate legal action. The legal action might result in salary garnishment, bank account garnishment, or seizing personal/business assets not used as collateral. If you had a co-signer/guarantor, lenders will go after them and their assets. 

If you default on an auto loan or logbook loan, the lender has the right to repossess the vehicle, i.e., take back the car as they have a lien. After repossession, the lender sells the car, and if the sale of the repossessed vehicle does not cover the outstanding loan amount, you may be held responsible for the deficiency.

Defaulting on a mortgage can lead to foreclosure, the legal process through which the lender takes possession of the property. This can result in the forced sale of the home by the lender to recover the outstanding debt. Like auto loans, any excess money will be returned to you, and you'll be on the hook for any deficiency.  

For secured business or personal loans, default can lead to the lender seizing the collateral specified in the loan agreement. For example, you may lose your property if you took a personal loan using your title deed and default. 

Finally, defaulting on digital loans, credit card debt, and overdraft loans often result in higher interest rates and additional fees. The lender may also reduce or revoke your credit limits and negatively list you on CRB. 

Read Also: The High Cost of Not Comparing Loan Options

How to Avoid Loan Default 

The best way to avoid default is to evaluate your ability to repay. Before you apply for a loan, review your finances and develop a repayment plan. This will simplify your borrowing and repaying process and ensure you make good decisions. 

Other steps to take to avoid default include:

  1. Responsible Borrowing:
  • Borrow only what you truly need and can afford.
  • Compare lenders to find the best terms before committing to a loan.
  • Understand your rights and the terms of the loan agreement.
  • Use the loan for its intended purpose to ensure financial responsibility.
  1. Keep Your DTI (Debt-to-Income Ratio) Low:
  • Avoid taking on more debt if your disposable income is limited.
  • Be mindful of your overall debt relative to your income.
  1. Emergency Fund:
  • Build an emergency fund to cover unexpected expenses.
  • Having savings can prevent reliance on credit during challenging times and a situation where you have to delay debt repayment to cover unexpected expenses.
  1. Live Within Your Means:
  • Create a detailed budget that outlines income, savings, expenses, and debts.
  • This will help you prioritize debts in your budget and avoid overspending.
  1. Loan Refinancing:
  • Consider refinancing your loan if it can offer better terms and lower interest rates.
  • Refinancing can ease the monthly burden, making it more manageable. However, you might be forced to extend the loan term and pay more interest over time. 
  1. Debt Consolidation:
  • If you have multiple loans, consolidating them into a single loan with favorable terms can make repayment more manageable. However, be wary of early repayment penalties and the total cost of loan consolidations. 
  1. Increase Your Income:
  • Additional income can provide financial stability and act as a buffer during challenging times, reducing the risk of default.
  • If your monthly repayment has gone up and you think you might default, seek opportunities to boost your income.
  1. Talk To Your Lender ASAP: 
  • Contact your lender immediately after you realise you cannot make your payments and stay in touch moving forward. 
  • Your lender will assist you with any problems you may be experiencing and can help you modify your loan or offer you a temporary break (permission to miss payment) as you get your finances in order. 

Read Also: What is Top Up Loan and How Does It Work in Kenya?


Once you miss a payment, your lender is likely to report the default to Credit Reference Bureaus (CRB). This action can have immediate repercussions on your credit score, making future borrowing more challenging. 

A bad credit score can affect your ability to secure favorable terms on financial products, such as consolidation loans, buyoff loans, or refinancing, that you may need to avoid default.

When you eventually default, the lender will get you blacklisted on the CRB. This will make borrowing even more challenging, as lenders see you as a higher-risk borrower.

Defaulting doesn't absolve you of your financial obligations. The longer you stay in default, the more interest compounds and additional fees accrue, increasing the overall amount owed. You will eventually pay more to clear the debt. To exit default, you'll need to obtain a CRB clearance certificate and start the challenging task of rebuilding your credit from scratch. 

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Farah Nurow is an experienced Content Writer who enjoys writing creative and educative articles meant to provoke readers' thoughts. He loves sunny weather and thick books. You can connect with him on LinkedIn.

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