1. How Financial Institutions Handle Defaulted Loans
2. Penalties For Borrowers in Default
3. How to Avoid Default Rates
4. Student Loans and Default Rates

A default rate is the percentage of loans issued by a financial institution that has been unpaid for an excessive amount of time. When a loan is in default, the lender typically writes it off as uncollectible on its financial statements and sends the account to a collection agency.

Lenders use default rates to determine their exposure to risks from their borrowers. Default rates are also considered an indicator of the overall economy's state of health.

How Financial Institutions Handle Defaulted Loans

When a borrower signs an agreement for a loan with a financial agency, such as a mortgage, personal loan, or credit card agreement, they are expected to make payments as agreed upon, on a regular monthly basis. When a borrower misses a payment, they risk damaging their credit score. Here is what happens next:

  • If two consecutive payments are missed, the financial institution will report this to credit reporting agencies. This is considered 60 days' delinquency.
  • If the borrower continues to miss payments, the lender will keep sending this information to credit reporting agencies up until a certain amount of time, which varies by lender. Typically this will be six months, after which the loan is considered to be in default.
  • When the loan is in default, the borrower will be contacted by collection agencies, at which point their arrangement with the original borrower ends.

Defaulting on a loan or credit card will seriously affect the borrower's credit score. This, in turn, makes it more difficult for that borrower to receive approval for loans in the future. It can affect the borrower in several other ways, as well.

Penalties For Borrowers in Default

Lenders have a few strategies for collecting on delinquent loans and preventing them from being late in the first place. One of these is to apply penalties to borrowers.

Most lenders will do nothing until the borrower has missed two consecutive payments. At this time, not only will lenders report the missed payments to credit reporting agencies, but they also may penalize the borrower by applying a substantially higher interest rate to their remaining debt.

Lenders publish these terms in the lending agreement that borrowers must sign when issuing the loan or credit line. This penalty rate is also referred to as a default interest rate or delinquent interest rate.

How to Avoid Default Rates

It's always tempting to apply for credit cards and loans that offer super-low interest rates. However, just two missed payments mean your interest rate could skyrocket to nearly 30 percent. You can avoid this, however, by making all payments on time. If you are late, make sure you catch up before you are delinquent by 60 days.

You should also make sure your credit card balance remains below the credit limit you are given. If the balance goes over the limit, the credit card issuer may switch you to the higher default rate. The default rate can also be triggered if the issuer returns a check to your bank for insufficient funds.

Student Loans and Default Rates

The status of student loans issued by the federal government is an important economic indicator. The Education Department reports that the percentage of borrowers that do not make payments in their first three years post-graduation has risen over recent years. The current default rate is about 11 percent.

The student loan default rate is important because it determines whether or not a college or university will be eligible to receive student aid from the federal government. If a college has a default rate above 30 percent for three years in a row or 40 percent in one year, the Department of Education can restrict the amount of funds available for students.

According to the Education Department, most of the colleges that have recently hit the default rate threshold are cosmetology or barber schools. This includes seven for-profit institutions, two public colleges, and one private university. When this occurs, the college must undertake an appeal process to the Education Department in order for its students to have eligibility for federal grants and loans to assist with tuition.

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