What Is Default?
Default is the failure to repay a debt, including interest or principal on a loan. A default occurs when a borrower fails their financial obligations by not making timely payments, missing payments, or stopping payments altogether.
Defaults can occur on secured debt, such as mortgages, or unsecured debt, including credit cards or student loans. Consequences include lowered credit score, reduced chances of obtaining new lines of credit, and foreclosure
What Is a Mortgage Default?
Defaulting occurs when the borrower fails to make payments to their mortgage
loan servicer and falls behind—putting them at risk of foreclosure
. Generally, this process is started within days of a failed payment. Even if the property is not lost during a foreclosure, having a default on your credit report lowers your credit score.
What Happens If I Default on My Mortgage?
If you fail to comply with the terms of a mortgage, then you’re considered in default. The lender can then demand that you immediately repay the entire outstanding balance—also called accelerating the debt.
If you don’t repay the full loan amount, or "cure the default," the lender can foreclose. The most common reason for default is falling behind on the required monthly payments. However, breaching other terms in the loan contract can also trigger default.
For instance, default can happen if:
- You fail to pay property taxes
- You don’t pay homeowners’ insurance
- You allow the property to deteriorate or cause damage that lowers the value of the home
- You transfer the deed to the property to a new owner without getting the lender’s permission.
When a borrower defaults on a loan, the risks can include:
- Negative marks on credit report
- Lower credit score
- Reduced chances of obtaining future credit
- Higher interest rates on debt
- Garnishment of wages and other penalties
- Increased tax bill.
Foreclosures stay on your credit history for up to seven years. And you can't just walk away from your mortgage. If there's a hefty loan balance, your lender may come after you for collection, also known as a deficiency judgement.
Bankruptcy might be a post-default option. However, mortgage liens are not forgiven during bankruptcy. If you owe the bank money and file bankruptcy you will not own the home free-and-clear. This is unlike default on other types of loans, such as credit cards and unsecured personal loans.
Student loans can be discharged with bankruptcy, although it’s still very difficult.
How Can I Get out of Default?
Start by trying to negotiate with your lender on an affordable repayment plan. This can be done by spreading repayment of the past due amount over several months by adding the extra onto your regular monthly payments.
Consider requesting mortgage forbearance if your financial problems are only temporary. This includes getting a reduction or suspension of monthly mortgage payments for a period of time—typically up to 90 days.
Borrowers may also apply for a mortgage loan modification to get a lower interest rate and longer repayment period. Depending on the reason for your financial troubles, mortgage modification may even forgive some of the loan principal.
Finally, you can ask your lender to consider a short sale
agreement. If you don’t qualify for loan modification, your lender may be willing to accept a payoff amount for less than what you owe on your mortgage loan and forgive the remaining balance.
How Does the Foreclosure Process Work?
Foreclosure allows a lender to recover the amount owed on by defaulters by selling or taking ownership of the property. While the process varies by state, it usually follows six phases:
1. Payment Default
Payment default happens when the borrower has missed at least one mortgage payment. At this pooint, the lender sends out a nonpayment notice. After two nonpayments, the lender sends out a demand letter.
2. Notice of Default (NOD)
A notice of default is sent out after 90 days of nonpayment. Typically, the lender's local foreclosure department will take over the loan. Once the borrower is notified, lenders typically allow 90 days to settle the loan or initiate the reinstatement period.
3. Notice of Trustee's Sale
If payment has not been met within 90 days following the NOD, a notice of trustee’s sale will be recorded in the county where the property is located. The lender will publish a notice in the local newspaper for up to three weeks with the owner’s name and other details.
4. Trustee's Sale
The property is placed for public auction and will be awarded to the highest bidder. The lender will calculate an opening bid based on the outstanding loan and any liens or unpaid taxes. A trustee's deed
is given to the winning bidder, who is entitled to immediate possession.
5. Real Estate Owned (REO)
If the property is not sold during a public auction, it is referred to as real estate owned (REO) or “bank-owned.” Lenders will also remove some liens and other expenses to make the property more attractive, and attempt to sell the property through a broker or asset manager.
The borrower can stay in the home until it is sold through public auction or later as an REO property. An eviction notice is sent once the home is sold. Several days will be allowed for occupants to remove personal belongings.
How Does a Financial Crisis Affect Default Rates?
During what economists consider normal times, the default rate on subprime mortgages ranges from three to four percent. During the financial crisis of 2008 and 2009, the subprime market default rate went up to roughly 70 percent.
Defaults spike during these times because people are lose their jobs and the value of their assets is declining—including their home value. When pricing mortgages or related financial products, lenders use the models of past default rates as a basis. Typically, banks' standards tighten and default rates fall following a financial crisis, as do the number of mortgages.
What Is a Strategic Default?
A strategic default is the decision by a borrower to stop making payments despite having the financial ability to make payments. Strategic default tends to occur after there’s been a large drop in the property’s price, which can put it underwater—where more debt is owed than the property is worth. Borrowers that believe the values will fall further or won’t rebound for the foreseeable future may choose to walk away from the loan and property. It’s estimated that one-in-five troubled mortgages during the Great Recession
were strategic defaults.