Here's What Happens When You Default on Your Loans

You know what to expect if you're caught driving over the speed limit or nabbed cheating on your taxes. However, you may not know what you're in for if you default on a loan. Here, we outline how a default can impact your life and suggest ways to avoid a default in the first place.

Your credit score takes a hit

Your FICO® Score, the score most commonly used by lenders, can drop by 100 points if you miss a payment by 30 days. How much it will drop following a default depends on several factors, including how old your credit history is and what your credit score was before the default.

Imagine that you have a score of 750. That puts you in the "very good" category. Your score is high enough to qualify you for the best deals and lowest interest rates. If your score drops to 650, you drop to the "fair" category, and lenders consider it riskier to loan you money. To protect themselves, they charge a higher interest rate and more fees.

Here's how a lower credit score can hurt you. Let's say your car dies, and you need to purchase a dependable used model that's large enough to chauffeur the dogs and kids around town. You find the perfect vehicle for $20,000 and borrow the money to pay for it.

The most important thing to remember is this: The lower your credit score, the higher your interest rate. For example, if the lender would have offered you an interest rate of 6% with a credit score of 750, the interest rate could be double that (or more) once your score takes a serious hit. Here's how the difference adds up:

At first glance, it doesn't look so bad. After all, the payment will only cost you $58 more a month. However, over the life of the loan, you'll pay nearly $3,500 more in interest. That's $3,500 you could use to build an emergency savings account, invest, or take a long-awaited vacation.

You can take steps to raise your credit score, but as long as it remains low you can count on paying more for loans.

Legal problems may hound you

If a loan is in default for months or years, a creditor has the legal right to take you to court -- as long as the statute of limitations has not run out. Typically, the statute of limitations is three to six years, although some types of debt allow lenders more time to take legal action.

But you can't consider yourself free and clear once the statute of limitations has passed. A creditor may no longer be able to take you to court, but it can still try to collect by contacting you directly or by hiring an outside firm to collect on their behalf.

If a debt collector gets in touch with you, your best bet is to ask for the name and address of their company and send a certified letter requesting that they cease all contact. Once they've received that letter, further contact may be illegal.

Failure to pay taxes or child support can absolutely land you in lockup. However, failure to pay a "civil debt" like a credit card statement or hospital bill won't doom you to a life behind bars. Do not allow an unscrupulous debt collector to convince you otherwise.

Under the Fair Debt Collection Practices Act (FDCPA), debt collectors are not allowed to threaten arrest. Yes, you can be sued, and yes you can be hounded, but you won't be jailed.

Bankruptcy may seem like the best option

Once a loan goes into default and you're stuck dealing with the aftermath, you may feel as though bankruptcy is your only move. Your options will be to file either Chapter 7 or Chapter 13. Chapter 7 wipes out all your balances, while filing Chapter 13 means repaying the debt over a three- to five-year period.

Either way, bankruptcy impacts your credit score and can make it difficult to rent a home, lease a car, or even land a job. Plus, Chapter 7 stays on your credit report for 10 years, and Chapter 13 lingers for seven years.

Three steps to avoid defaulting on a loan

The best way to avoid any of these scenarios is to keep an eye out for issues that frequently lead to default. For example:

1. Limit loans and credit card use

Do not use a credit card or loan to buy something you're not sure you can pay off quickly. Ideally, you'll plan to pay your credit cards off in full each month and use loans sparingly.

2. Always make on-time payments

No matter what you've got going on in your life, prioritize getting payments in on time. If you can't pay something off in full, make sure to pay at least the minimum. The easiest way to ensure that payments are never late is to set up autopay for bills whenever the option is available.

3. Make the first move

No one knows your monthly budget as well as you. If you've fallen behind on a financial obligation, contact your creditor to negotiate. Ask about setting up a different repayment plan or settling your debt with a single lump-sum payment. Both actions will lower your credit score, but the damage may not be as dramatic as a default.

Of course, if you've already defaulted on a loan, your immediate concern is doctoring your credit score back to health. It will take time and effort, but as millions before you have illustrated, it can be done.