Loan Defaults On The Rise: How It Can Hurt Your Finances And Credit Score

Defaulting on a loan repayment can have long-term financial consequences. Notably such defaults can negatively impact the credit rating and future borrowing prospects of an individual. The Fintech Barometer (Vol II) report, published by CRIF High Mark and the Digital Lenders Association of India (DLAI) in January 2025 indicates an increasing trend in defaults on small personal loans.

The report shows delinquency in loans below Rs 10,000 has increased, mainly for the period between December 2023 and June 2024. The report added that one of the causes of delinquency is that Non-Banking Financial Companies (NBFCs) have started lending to borrowers outside the top 100 cities and new borrowers have a higher likelihood of defaulting. 

If the borrower fails to make a scheduled loan repayment, lenders charge late payment fees and penalties. The delay can snowball into higher interest rates, raising the total amount of money which needs to be repaid. High-interest borrowers end up suffering even more if they default on loan repayment as the compounding interest and penalties raise the total debt burden higher.

How Defaulting On Repayments Adds to Debt

Let us take an example of a borrower who took a personal loan of Rs 1,00,000 at an interest rate of 12 per cent per annum for a tenure of 3 years. The monthly EMI would be approximately Rs 3,321. Over the entire loan tenure, the borrower will repay a total of Rs 1,19,572, which includes Rs 19,572 in interest along with the principal amount of Rs 1,00,000.

However, if the borrower defaults on an EMI, penalties and additional charges come into play, further increasing the repayment amount. A typical penalty for a missed EMI includes a late payment fee, which is usually a percentage of the overdue EMI amount, ranging between 1 per cent and 3 per cent, depending upon the lender. In this case, assuming a late payment charge of 2 per cent on the EMI amount, the penalty per missed EMI would be Rs 66 (2 per cent of Rs 3,321). If the borrower fails to make payments for three months, the total late charges would amount to Rs 198 (Rs 66 x 3).

The unpaid EMIs themselves contribute significantly to the outstanding balance. Over three months, the borrower would accumulate unpaid dues of Rs 9,963 (Rs 3,321 x 3), which would then be added back to the loan balance. The additional amount including 3 months EMI amount + 3 months late charges) becomes Rs 10,161.

As a result, after three months of default, the borrower's total outstanding amount would rise to Rs 1,10,161. While this may seem manageable compared to the original planned repayment of Rs 1,19,572, accumulating penalties and overdue amounts can strain finances, making it harder to catch up with payments.

It can also very easily get out of hand soon and the borrower may be tempted to apply for another loan to settle the arrears. Eventually, the cost of mounting debt proves expensive for borrowers and impacts their overall economic health.

Impact on Credit Score

Credit scores range between 300 to 900, and a credit score of more than 750 is considered good. A missed payment of a loan lowers the score drastically. A missed EMI can lower the credit score by 50 to 70 points depending on the nature of the borrower. For instance, if a borrower has a credit score of 780, two consecutive defaults of EMI can potentially lower it to 650.

A lower credit score can reduce the chances of your loan application being approved. Additionally, a low credit score can also lead to the loan being approved at a relatively higher rate of interest and with stringent repayment terms.

Legal Implications 

When a borrower defaults on a loan repayment, lenders can pursue the case in court. Legal proceedings in turn result in court orders, seizure of assets, or even wage garnishment, wherein a part of the income of the borrower is legally deducted for settling the debt. Banks can also mark defaulters in their credit information reports with companies like CIBIL, Equifax, and CRIF High Mark, so that they are unable to access credit in the future.

Long-Term Consequences

Aside from legal issues and financial losses, loan defaults have implications on an individual's life and career. Having a bad credit score can also make life difficult for renters as landlords typically check the credit score of prospective tenants before permitting them to rent an accommodation. Bad credit can also impact an individual’s employment opportunities, especially in institutions such as banks, finance firms, and government offices.

Pressure to reply to collection agents, court notices, and financial uncertainty creates mental health issues concerning psychological problems, causing tension and psychological suffering. Most defaulters have a crisis of confidence, which makes them incapable of improving their finances after default, for which reasons proactive action must be initiated well in advance before it reaches default stages.

How to Prevent Loan Defaults

Afzal Payak, loan and debt indication expert and founder of 100 Ways Group, said, "The prevention strategy depends upon what kind of borrowing the borrower has entered into. The first and foremost thing is that you need to borrow a loan very wisely, defining your end-use specifically, and you cannot use funds for some other purpose. If you have borrowed funds for a certain purpose, you should not divert your funds. Fund diversion is a major reason for default in loans".

On the same subject, Atul Monga, CEO and co-founder of BASIC Home Loan said, "Borrowers can recover from default on loans and enhance their credit rating, but it takes time and discipline. The first step is to pay off the outstanding debt, either in full or through a settlement with the lender, to prevent further erosion of the credit rating. Being regular with the repayment schedule and paying all dues that are pending on time is also necessary. Consistency in the payment of debts will over time strengthen credit scores. One should also be careful to manage finances well and utilize credit wisely. Try not to get new loans or credit cards while your score gets better. Carefully review the credit report often for mistakes or discrepancies, because errors can cause harm to the credit score. Applying for a secured credit card can also help improve your credit score if used responsibly".

Early stages of communication with banks can assist in negotiating improved repayment terms. Banks usually provide loan restructuring in the form of increased loan tenure, reduced EMIs, or interim relief options to enable borrowers to escape default.

Payak said that a person can take a loan again after he has defaulted on the previous one. He added "So there are certain defaults, which can be ignored, which happen on a situational basis... if there is a repayment delay in certain loans from the borrower, say every month, he has delayed an EMI payment by 10-15 days, because of (some unforeseen) reason. Now the business has recovered...and he is paying his EMI regularly. So in this case he can apply for another loan immediately. And based on his circumstances, banks will take a call". 

"Lenders want creditworthy borrowers, so chances are slim for an instant approval after a default. Some lenders may take borrowers who have defaulted previously if they paid off the past loan, though this is often at increased interest rates. This is more possible with secured loans. If you have a short-term need, NBFCs can be a good choice since they have relatively more lenient lending terms. But NBFCs tend to charge a bit higher interest rate. Ensure that you know the terms of the loan before committing. Also, ensure that the NBFC is RBI-registered. Alternatively, you may also opt for a loan with a co-applicant who possesses a good credit rating. This will increase your loan approval prospects as well as make you eligible for a higher amount of loan. Nevertheless, note that the co-applicant would also be held liable if you default on the loan. Therefore, both parties should be well aware of the risks involved", stated Monga.

It is also helpful to seek financial assistance from credit advisers or financial consultants. Such advisors give guidance on payment modes, budgeting, and debt planning that assist lenders in controlling their money once more. Additionally, having an emergency fund of three to six months' worth of expenses can be a buffer against any unexpected event and cut down defaults on loans.

Defaulting on a loan is not only a short-term loss—it has long-term effects on credibility, borrowing power, and legal position. With the rise in defaults on loans, particularly for small personal loans, lenders must exercise financial discipline in order not to get caught in debt traps.