Understanding Loan Defaults and the Consequences

By Phineas Upham

Loans have a legal structure to them that ensures the borrower will repay the loan, while protecting that borrower from the lender placing additional conditions upon the loan. It’s a two-way contract that outlines the responsibilities of both parties. If that contract is breached, the loan goes into default.

Of course, corporations and government entities can be held accountable on defaults if they fail to re-pay bonds. This is very much the current situation for Puerto Rico, which has not issued payments on its bonds and has suffered a downgrade in credit rating because of it.

Default is very different from insolvency or bankruptcy. When someone is insolvent, they are unable to repay their loan so it’s not a matter of choice. Bankruptcy, on the other hand, discards choice for court-ordered supervision over financial records. In all cases, the borrower is required to repay the debt. The difference comes in how the courts view that individual’s ability to do so.

If an individual defaults on a loan, there are severe consequences including exclusion from future federal loans or grants. Major damage is done to one’s credit report, and the courts can order a garnishment of wages in order to extract repayment. In some cases, default can result in the court revoking a professional license or certification.

When a nation like Greece or Puerto Rico defaults, they too take a major hit to their credit rating. That ding is typically associated with higher borrowing costs. Governments may try to print more money, which leads to inflation. They are able to pay a loan back under these conditions, but they do so with a currency that has been devalued.

About the Author: Phineas Upham is an investor at a family office/ hedgefund, where he focuses on special situation illiquid investing. Before this position, Phin Upham was working at Morgan Stanley in the Media and Telecom group. You may contact Phin on his Phineas Upham website or LinkedIn page.