Borrowing: What are the Risks of Borrowing Money (16th Blog Post)

Borrowing money involves serious risks. Remember that a lender expects you to compensate them for taking money that belongs to them and allowing you to temporarily use it. And a lender also expects you return to them what you have borrowed from them. To deter borrowers from failing to make interest payments when they come due and from failing to repay the money that has been lent to them, there, practically speaking, has to be a set of severe consequences that borrowers face in such scenarios. It should come as no surprise, therefore, that indeed there are.

Lenders commonly require interest payments be made on a monthly basis. (So, in practice, a borrower is typically required to pay each month 1/12 of their annual interest expense obligation.) When borrowers fail to make their interest payments on time, lenders typically charge borrowers “late fees”. Late fees are a type of penalty and they can add up. As we illustrated in our 15th blog post (“Borrowing: What are the Costs of Borrowing Money”), accumulating late fees can cost a borrower a lot of money over time as well as negatively impact their credit history[1] and “credit scores”.

When a borrower misses a loan payment, their loan becomes “past due” or “delinquent”. The loan will remain “delinquent” until the borrower repays the amount that is due to the lender. However, after a certain number of days past due (e.g., after 30, 60, 90, 120, 180 days past due) the lender will move the loan from “delinquent” status into “default” status. While technically one has defaulted on a loan when one misses a loan payment, defaulting in practice usually means that one has failed to make payments on a loan for several months. In practice, the timing of when consumer loan defaults are exactly triggered varies by both lender and type of consumer loan.

Loans can be “secured” or “unsecured”. A “secured” loan is one in which the borrower has pledged “collateral” against the loan. “Collateral” involves one or more assets that have been pledged by a borrower to a lender in the event the borrower defaults on the loan that they receive. An example of collateral is a home in the case of a home loan and a car in the case of a car loan. If a borrower defaults on a home loan and that home loan is secured by the home that the loan was used to purchase (which is typical of home loans), then the lender has the legal right to take ownership of and sell that borrower’s home. If a borrower defaults on an auto loan and that auto loan is secured by the vehicle that the loan was used to purchase (which is typical of auto loans), then the lender has the legal right to take ownership of and sell that borrower’s vehicle. Personal loans are typically unsecured although sometimes they are secured. Ultimately, for secured personal loans, borrowers and lenders have to negotiate what will serve as the agreed-upon collateral since it is not nearly as standard as the collateral used in home loans and auto loans. Examples, though, of collateral used in secured personal loans may include things like cash in a savings account, investments, a car, a home, jewelry, art, collectibles, and antiques. If a borrower defaults on a personal loan and that personal loan is secured, then the lender has the legal right to take ownership of and sell the collateral that backs the loan.

As you can imagine, lenders like collateral because it helps protect them against taking a loss (through hopefully recovering the full amount of the loan and perhaps interest owed as well) in the event a borrower defaults on a loan. But if you are a borrower and you have to pledge collateral against a loan you take out, you have just assumed serious risk. In the case of a home loan, you literally could lose your home if you default on the loan. In the case of a car loan, you literally could lose your car if you default on the loan. In the case of a secured personal loan, you literally could lose whatever collateral you agreed to back the loan with. Maybe that is cash in your savings account, or investments you have, or your car or home, or jewelry or art that you have. Whatever it is, you risk losing it. Additionally, and a separate serious risk, is the damage you do to your credit history and credit score if you default on a secured or unsecured loan. More on that to come.

Personal loans, credit card debt, and student loans are all typically unsecured forms of debt, meaning that the borrower typically does not have to pledge any collateral against these types of loans. So you may be wondering, well if a borrower does not need to pledge any collateral against these types of loans, then what is to prevent a borrower from deciding to simply walk away from their loan payment and loan repayment obligations. The short answer: a lot!

For one, when we become adults we will develop credit histories and credit scores. An individual’s credit score is a quantified indicator of that individual’s creditworthiness, i.e., an indication of how likely is it that the individual will be able to make interest payments owed on loans and repay the principal of loans. A person’s credit score -- which is influenced, among other factors, by one’s credit history including one’s loan payment history -- impacts the lending decisions of lenders, including whether to even make a loan to the given individual in the first place and how much to lend and what interest rate to charge in the event they are willing to issue a loan.

If a borrower does not make interest payments when they come due or repay the money that has been lent to them, regardless of whether the debt is secured or unsecured, then that borrower’s credit history and credit score will be damaged. (When borrowers miss payments, lenders report the missed payments to the credit reporting agencies who collect, analyze and report such data to lending institutions broadly. Lenders will also continue to update the credit reporting agencies on the length of time that a borrower’s missed payments are overdue.) And the longer a missed payment remains outstanding, the more one’s credit score will decline. If a borrower’s credit history and credit score are damaged, then that borrower’s ability in the future to both access credit and access lower-cost rather than higher-cost credit will be harmed as well. Said differently, if you damage your credit history and credit score, it will be increasingly difficult for you to secure a loan in the future (e.g., a credit card loan, a personal loan, a home loan, a car loan) and, if you can get a loan, it will likely be more expensive than it would otherwise be.

Secondly, when one defaults on their unsecured loan, the lender does not just throw up its hands and say, “oh well, my bad luck”. Rather, the lender itself, or a third-party debt collections agency to whom the lender has sold the defaulted loan or whom the lender has hired to collect the outstanding debt on its behalf, will attempt to recover the debt that the delinquent borrower owes. The lender or third-party debt collector typically will repeatedly call, email and even text the borrower to collect the money that the borrower owes. That tends to create its own serious headache for delinquent borrowers. If unsuccessful, though, the lender or third-party debt collector may then file a lawsuit against the delinquent borrower and take the borrower to court to collect what is owed. Remember, a loan involves a legal agreement between a borrower and a lender. If the borrower defaults on their loan, then the borrower has violated their legal agreement. In such cases, a judge will decide how to force the delinquent borrower to pay back what it owes.

A common means courts force borrowers of unpaid debt to pay back the debt they owe is through what is called “wage garnishment”. Wage garnishment, in the case of delinquent borrower lawsuits, involves a court-imposed legal requirement on a borrower’s employer to withhold a portion of the delinquent borrower’s income from their paycheck and the requirement to send the lender the amounts withheld until the debt is repaid. Wage garnishment can be in the form of wages, salaries, bonuses and commissions that are paid to the borrower by the borrower’s employer. Courts may also require that tax refunds due to a borrower be withheld and applied towards repayment of a defaulted loan.

Another legal judgement in lawsuits related to loan defaults can be, for example, the placement of a “lien” – i.e., a legal claim -- on assets that the borrower owns (assets such as a home or car), effectively turning those assets into collateral that can now be used to repay the borrower’s debt. In these circumstances, the lender or third-party debt collector is not seizing ownership of and selling the given asset on which the lien has been placed. Rather, the courts simply make it extremely difficult for the borrower to ever sell, or refinance a loan backed by, the given asset without paying back the debt that they owe (otherwise referred to as “paying off the lien”).[2]

By the way, we would be remiss to not point out the obvious in any discussion related to lawsuits: lawyers are not cheap. Legal fees tend to add up quickly, another reason why a borrower does not want to risk defaulting on their debt obligations.

Lastly, remember how we mentioned that if you damage your credit history and credit score, it will be increasingly difficult for you to secure a loan in the future (e.g., a credit card loan, a personal loan, a home loan, a car loan) and, if you can get a loan, it will likely be more expensive than it would otherwise be? Well damaging your credit history and credit score potentially may also negatively affect:

• Your ability to rent an apartment or house. (Landlords want to have confidence that you will be able to make your rent payments when they come due.)

• The cost of insurance that you buy. Insurance companies in many cases conduct credit checks as a means of gauging the risk of providing insurance to a potential customer. Studies suggest that those with worse credit scores are more likely to file insurance claims[3]. Insurance claims cost insurers money.

• Even possibly employment opportunities. Employers in many cases may conduct a credit check as part of their overall background checks on job applicants. They do this to help assess how a job applicant handles personal responsibility. In the event, though, that the given job applicant is applying for a role in which they will have money-handling responsibilities, employers conduct credit checks also to reduce the risk to themselves of potential theft or the use of funds for unintended purposes.

In sum, if, when you become an adult, you are going to borrow money, do so responsibly and with your eyes wide open with regard to the risks of assuming debt.

I would love to hear from you. Any ideas, experiences, thoughts, comments and questions….please do share.

[1] A consumer’s credit history is officially captured, and made available to lending institutions, by what are called in the United States “credit reporting agencies” or “credit bureaus”. A person’s credit history includes, for example, their loan payment history, their total outstanding debt, the types of credit they have received, the length of their credit history, whether any lenders have the legal right to take ownership of and sell assets that the person has used as collateral for any current outstanding loans, and whether the person has had any personal bankruptcies and/or legal judgements issued against them that may be relevant to their credit history.

[2] In order to sell, or refinance a loan backed by, an asset like a home or a car, you need to have clear “title” to that home or car. “Title” is a legal right to ownership of a property, including the legal right to transfer ownership of that property (i.e., to legally sell the property). Liens on assets make the title to those assets unclear. One way to clear up title to an asset is to pay off any liens placed on that asset since liens involve unresolved payments tied to the given asset. Once any liens are released as a result of the borrower using the proceeds of any sale or loan refinancing to pay back the debt that they owe, then clear title is established.

[3] Insurance Information Institute, “Background on: Credit Scoring”.

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