In financial terms, default refers to a debtor who has not been able to meet his/her legal obligations, in accordance with the debt agreement. This can mean either not making a scheduled payment, or violation of a loan condition in the debt agreement. Simply speaking, default means not paying back the loan. It may take place when either the debtor is unwilling or is incapable of paying the debt. Default may happen with all kinds of debt obligations like bonds, loans, mortgages, as well as promissory note.
How is default different from insolvency or bankruptcy?
Default refers to a debtor not paying a debt which was required to have been paid back. Insolvency is basically a legal terminology applicable for a debtor who has been incapable of paying his debts. The term bankruptcy is described as a condition which imposes court intervention over finance related affairs of insolvent or individuals in default.
Default – different types
Default is primarily of two kinds:
• Debt service default: This takes place when the debtor has failed to adhere to a payment schedule relating to interest and/or principal.
• Technical default: This takes place during the violation of an affirmative covenant or a negative covenant.
Affirmative covenants refer to certain conditions/clauses in debt agreements which require companies to maintain minimum capital levels or simply speaking, financial ratios. Negative covenants refer to those terms and conditions in debt agreements which limit corporate actions like paying dividends, or selling of assets, which could harm the creditors’ positions. Cases of violations associated with negative covenants have been uncommon in comparison to violation with regard to affirmative covenants.
In majority of debt cases like corporate debt, bank loans and mortgages, a covenant is added into the debt contract stating that the sum owed immediately becomes payable at the first occurrence of payment default. Usually when the borrower defaults in relation to any debt with a lender, a cross default covenant is included which claims that, that specific debt is even in default.
In the world of corporate finance, in a situation of uncured default, the debt holders usually begin filing petition relating to involuntary bankruptcy and initiate proceedings for foreclosure on some collateral. Even if it is an unsecured debt, debt holders can still sue with regard to bankruptcy for ensuring that the company’s assets are made use of for repaying the debt.
What is universal default?
In case of a financial service industry, this refers to the practice of a lender changing loan terms and conditions, from regular to default terms, if the lender gets to know that the specific customer had defaulted with payments with regard to some other lender in the past. The rates and the terms are revised on account of the customer having missed payments in the past on a debt or a loan.
Credit card companies mostly include the default language in the cardholder agreements. However not all credit card companies have enforced the provisions systematically. In fact, several bills have been passed by the Congress since 2003 to eliminate the universal default provision of credit card issuers.