Default (finance) facts for kids

In the world of finance, a default happens when someone fails to keep their promise to pay back a loan. It's like when a family doesn't make their house payment, or when a company or government doesn't pay back money they borrowed. When a country doesn't pay its national debt, it's called a sovereign default.

One of the biggest private defaults ever was by a company called Lehman Brothers. They owed over $600 billion when they went out of business in 2008. The largest government default was by Greece, which owed about $138 billion in 2012.

What's the Difference: Default, Illiquidity, Insolvency, and Bankruptcy?

These words might sound similar, but they mean different things:

• Default: This means someone has missed a payment they were supposed to make on a loan.
• Illiquidity: This means someone doesn't have enough cash or things they can quickly turn into cash to pay their bills.
• Insolvency: This is a legal term meaning someone simply cannot pay their debts.
• Bankruptcy: This is a legal process where a court steps in to help manage the money problems of someone who is insolvent or has defaulted.

Types of Default

There are two main ways a default can happen:

Debt Service Default

This is the most common type. It happens when a borrower simply doesn't make a scheduled payment of interest or the main amount of the loan.

Technical Default

This type of default happens when a borrower breaks a rule or condition in their loan agreement, even if they are still making their payments on time. These rules are called "covenants."

• Affirmative Covenants: These are rules that require a company to keep certain financial levels, like having enough money saved or keeping certain financial ratios. For example, a loan might say a company must always have a certain amount of cash on hand.
• Negative Covenants: These rules stop a company from doing certain things that could hurt the people who loaned them money. For example, a loan might say a company can't sell off its main assets or pay out too much money to its owners.

If a borrower defaults on one loan, many loan agreements have a "cross default" rule. This means that if you default on one loan with a lender, all your other loans with that same lender might also be considered in default right away.

When a company defaults and can't fix the problem, the people who loaned them money might try to take ownership of anything the loan was secured by, like buildings or equipment. Even if there's no specific item securing the loan, lenders can still go to court to make sure the company's money and assets are used to pay back the debt.

When Countries Default (Sovereign Defaults)

Countries are different from people or companies because they usually aren't subject to their own bankruptcy courts. So, if a country defaults, it might not face the same legal consequences. Instead, the country and the people or organizations they owe money to will usually try to talk and agree on new terms, like changing the interest rate or how long they have to pay back the loan.

For example, Greece defaulted on a loan from the IMF in 2015. In 1998, Russia defaulted on some of its internal debts. And during its economic crisis in 2002, Argentina defaulted on money it owed to the World Bank.

Orderly Default

Sometimes, when a country is in a really big financial crisis, experts might suggest a "controlled" or "orderly default." This means carefully planning how the country will restructure its debt. The idea is that doing this in an organized way might actually be better for everyone involved, including the lenders and neighboring countries, than waiting for things to get even worse.

Strategic Default

A "strategic default" happens when someone chooses not to pay back a loan, even if they have the money to do so. This often happens with loans where the lender can't go after other assets of the borrower.

A common example is when someone owns a house that is worth less than what they owe on their mortgage. If the loan is "non-recourse" (meaning the lender can only take the house, not other assets), the homeowner might decide to stop making payments and let the bank take the house. People sometimes call this "jingle mail" because the homeowner might just mail the keys back to the bank.

Sovereign Strategic Default

Just like individuals, countries can also choose to strategically default. In 2008, the president of Ecuador, Rafael Correa, decided not to pay interest on some of his country's debt. He said he thought the debt was "immoral and illegitimate."

Consumer Default

Consumer default is when everyday people don't make payments on things like rent, mortgage, credit cards, or utility bills.

Studies have shown that certain groups of people are more likely to default, such as single households, people who are unemployed (even if they have a low income), and younger people (under 50). Not being able to rely on friends or family for help can also increase the risk. Even people who aren't good with the internet might be more likely to default, possibly because they find it harder to find out about social benefits they could get.

While it's usually better and less stressful to get financial advice and help without going to court, consumer default can sometimes lead to legal debt agreements or even personal bankruptcy. In some countries, like the UK, bankruptcy procedures can last about a year, while in others, like Germany, they can last up to six years.

Research in the United States has found that getting advice before buying a house can really help reduce the number of people who default on their mortgage payments.

Images for kids

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  A friendly robot

See also

In Spanish: Impago para niños