People default on their credit facilities primarily on account of the following reasons:
- Ineffective management of funds (income) and inability to manage expenses:
- Budgeting and managing expenses within one’s income is very important in this context. While in general, people do attempt to manage their funds, but the lack of a systematic approach in this matter leads to situations which cause default.
- Unforeseen Circumstances: At times, certain exigencies such as medical expenses, job loss, business downturn or similar circumstances lead to a gap between sources and uses of funds, causing an individual to default. ??
- Limited awareness and lack of understanding of how credit products function: The lack of understanding of the features, functionalities of credit product is another reason for people to default. In India, the lack of credit literacy and the absence of effective bureaus has been a significant reason for people to default (rather than the defaults triggered by the onset of unforeseen circumstances).
Irrespective of the reason for default, a default situation can have several unpleasant outcomes:
- Legal Action by the lender : Bouncing a cheque or not honoring a legal contract (which is what a loan is), can cause a lender to file a legal case against the borrower. In India, a cheque bounce is a non-bailable offence and can lead to jail.
- Loss of colateral : A secured loan is one which is associated with some form of security. In the event of default, lenders will are likely to sell the collateral to make good their losses
- Collection Visits by agencies : If you default, you ae likely to start to get calls from collection agencies for overdue payments. While there is a model code of consuct governing collection agencies, visits by collector can cause significant embarassment at a point when you are already feeling demoralised
- Lower credit score : Defaults lead to lowering of credit scores. A low credit score makes it more costly to get loans in future. At times, it becomes difficult to even get loans. A low credit score also has consequences in terms of job applications, insurance premiums and rent agreements.
In summary, defaulting on a loan can have disastrous consequences which go beyond the financial realm