The difference between arrears and default lies in their scope and severity: arrears refer specifically to overdue payments, while a default is a broader term indicating a significant breach of the terms of a credit agreement.
Understanding Arrears
Arrears occur when a payment is overdue. It signifies that you have missed a scheduled payment or have not paid it by the due date. Being in arrears is often the initial stage of financial difficulty with a specific payment obligation.
Examples of Arrears:
- A mortgage payment not made by its due date.
- An unpaid credit card bill after the statement's due date.
- A late installment on a personal loan or car finance.
- An overdue utility bill (e.g., electricity, gas, water).
While being in arrears is a breach of contract, it can often be resolved by making the overdue payment quickly, sometimes incurring a late fee.
Understanding Default
A default is a more severe and formal declaration by a lender that you have broken the terms of a credit agreement. While being in significant arrears is the most common path to default, a default can arise from various breaches of the contract, not just missed payments.
The lender formally records a default when they believe the agreement has been fundamentally broken, and they may decide to pursue the full outstanding balance or take legal action.
Common Reasons for Default
- Persistent Arrears: Consistently missing multiple payments or accumulating a substantial amount of overdue payments is the primary reason for a default being recorded. Lenders typically issue warnings before formally defaulting an account.
- Breaching Other Terms: This could include:
- Exceeding a credit limit repeatedly without authorization.
- Failing to provide required information or documents as per the agreement.
- Providing false information.
- Bankruptcy or other formal insolvency procedures (these are types of default on all relevant agreements).
Example of Default:
If you consistently miss mortgage payments for three to six months, your mortgage lender will likely send you a formal 'notice of default' stating that you have breached your mortgage agreement and outlining potential next steps, such as repossession if the situation is not rectified.
Key Differences Between Arrears and Default
The table below highlights the fundamental distinctions between these two financial statuses:
| Feature | Arrears | Default |
|---|---|---|
| Definition | Payments that are overdue. | A formal breach of the terms of a credit agreement. |
| Scope | Specific to missed or late payments. | Broader, encompassing various contractual breaches, including significant arrears. |
| Severity | Generally an early stage of financial difficulty. | A more serious and formal declaration by the lender that the agreement is broken. |
| Impact | Initial impact on credit may be minor but worsens with time; late fees. | Significant and lasting negative impact on credit score; can lead to collection activity or legal action. |
| Resolution | Often resolved by making the overdue payment(s) plus any late fees. | Requires formal action, negotiation with the lender for a repayment plan, or potentially legal processes. |
Impact on Your Credit Score
Both arrears and defaults can significantly impact your credit score and make future borrowing more challenging. Lenders view these as indicators of higher risk.
- Arrears: Even a single missed payment can be recorded on your credit report and negatively affect your score, though the impact usually increases with the number and duration of overdue payments.
- Default: A default on your credit file is a severe marker that remains for a considerable period (typically six years in the UK). It makes it much harder to obtain new credit, such as mortgages, loans, or credit cards, and any credit you do secure may come with much higher interest rates. It can also affect your ability to rent property or secure certain jobs.
Managing Financial Difficulties
If you are facing financial difficulties, it's crucial to address them proactively. Ignoring the situation can lead to more severe consequences like a formal default or even legal action.
Proactive Steps and Solutions:
- Communicate Immediately: As soon as you anticipate or miss a payment, contact your lender. Explain your situation. Many lenders have departments dedicated to helping customers in financial difficulty and may offer solutions like temporary payment holidays, reduced payments, or revised repayment plans.
- Budgeting: Create a detailed budget to understand your income and expenditures. Identify areas where you can reduce spending to free up funds for debt payments.
- Seek Free Financial Advice: Non-profit organizations offer free, impartial advice on debt management. They can help you understand your options and negotiate with creditors. Examples include Citizens Advice or MoneyHelper (in the UK).
- Prioritize Debts: Focus on "priority debts" first. These are debts where the consequences of non-payment are severe, such as mortgage/rent (risk of losing your home), utility bills (risk of disconnection), and council tax/income tax (risk of legal action).
- Explore Debt Solutions: Depending on your circumstances, solutions like Debt Management Plans (DMPs), Individual Voluntary Arrangements (IVAs), or even bankruptcy may be options. It's essential to seek professional advice before considering these, as they have significant implications.
