Whenever you borrow money, whether it's to go to school or buy a car, you're required to repay that debt as per the terms of your agreement with your lender. A failure to make scheduled loan payments when they come due is considered a default. The consequences of a loan default depend on whether the debt is secured or unsecured, but either way, an unpaid balance or delinquency on your record could have a serious impact on your credit.
Secured versus unsecured loans
Let's get one thing straight: Regardless of the nature of your loans, you're required to repay them on schedule, and any time you fail to do so, you run the risk of wrecking your credit. But the consequences of a loan default will very much depend on the type of debt in question.
A secured loan is debt that's related to specific collateral. Common examples include a mortgage, which is tied directly to your home, or an auto loan, which is tied directly to your vehicle. If you default on a secured loan, your lender might respond by reclaiming the property the loan was designed to help you finance. So if you default on your mortgage loan, you could be forced into foreclosure and lose your home. If you default on an auto loan, your lender might repossess your vehicle.
Unsecured loans work differently, as they're not related to specific collateral. Common examples of unsecured debt include credit card balances and student loans. If you default on a credit card payment, your lender can't come and take your car or house away. There are, however, other consequences to consider.
Defaulting on unsecured loans
When you default on an unsecured loan, your lender might send that debt over to a collections agency in an attempt to recoup its money. Furthermore, a lender might take legal action against you if you fail to make payments on an outstanding loan. You might, for example, have your wages garnished until your debt is repaid. Either way, you can count on your default lowering your credit score and making it more expensive for you to borrow in the future.
If you default on a student loan, the consequences could be equally dire. Not only will your default remain on your credit report, but if you fail to repay a federal loan, you might actually be barred from working for a federal agency. If you already work for a government agency but fail to make scheduled payments on a federal loan, you could get suspended or lose your job entirely.
Avoiding a default
If you're really in a financial crunch and don't think you'll be able to repay your loans, you should take steps to address the problem rather than go into default. You might try refinancing your loans to make your payments more affordable, or negotiating a payment plan with your lenders. Remember, lenders want to get repaid, and so they're often willing to work with you if it means getting their money.
If you're really unable to repay your debts, you might also consider filing for Chapter 7 bankruptcy. You'll have to meet certain eligibility requirements to go this route, but know that while it can help you wipe out some of your debts, it's by no means a picnic. A Chapter 7 bankruptcy will stay on your credit report for 10 years, and during this time, you might have trouble getting a car loan, renting an apartment, or even getting a job. Furthermore, if you're struggling to repay your student debt, filing for bankruptcy won't help. Student loans typically aren't dischargeable in bankruptcy.
Of course, the best way to prevent a loan default is to avoid taking on too much debt in the first place. Whether it's a mortgage, a car loan, or money for college, think before you borrow and pledge not to get in over your head. Defaulting on a loan can derail your finances in more ways than one, so the less you borrow, the greater your chances of keeping up with your payments.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!