Every wonder what
happens when you default on a loan?
Does the bank suffer
a huge amount when this happens? Well, as we saw on the previous page,
How Banks Work, banks are set up so
that money may be created from virtually nothing. So do we expect banks
to suffer when loans go bad and creditors - as sometimes happens in
life - become unable to pay their installments? No.
In fact, they make
a little profit from a combination of several things.
First there is the
insurance (which you have been paying towards, though you may not know
it). Secondly there is the tax break that writing off the loan gives
them. Thirdly, they get a few hundred when they sell the debt on to
a debt purchasing company (DPC) who will then try to recover the whole
amount (though they bought the debt for pennies on the pound), plus
their own expenses and fees, plus interest, and will spend the next
few months or even years making your life Hell in the process, using
tactics which may even involve breaking the law.
The bank knows the
DPC will do this, but they don't care. By this time they will be quids
Of course, the bank
doesn't want you to default. They want to keep you paying your monthly
installments to them for years and years. But when things go bad, the
banks are amply covered.
That's it in a nutshell.
But let's have a look at the various stages of what happens when you
default on a loan.
Of course, banks
do all they can to prevent you defaulting on a loan, and they also make
a very tidy sum by adding penalty charges to your account (typically
£35, sometimes more) every time you are late with a payment.
are making up to £3.5 billion a year from overdraft penalty charges,
the Office of Fair Trading (OFT) said yesterday."
Source: Times Online, Sept 12 2007
Such penalty charges
have since been declared as illegal, and thousands of people have benefitted
from successfully claiming back all their penalty charges from their
bank by way of credit card charges.
So the banks make
money when you are late with a payment. But what if you find yourself
in a position where you cannot meet the installments at all? (Lots of
people lose their jobs through no fault of their own, fall ill, or have
other things happen to them.) What happens when you actually default
on a loan?
There are a number
of ways that the bank makes money when you default on a loan.
that the bank will only ever lose about one twelfth (about 8%) of the
loan, because that's all it needed to have of its own money in the first
place (see the page on Fractional Reserve Banking in How
Banks Work). So even if you defaulted in the very first month, the
bank would only lose 8% of the whole loan value. If you have been keeping
up with your installments for a number of months, the chances are that
you will have paid back the bank all of the 8% it had originally invested.
But it still expects
you to pay back the other 92%.
So if you default
on your loan the chances are that the bank will have had all its "real"
money back anyway, and a whole lot more, plus interest.
But the bank is
allowed, by law, to pursue you for the whole amount. It may well start
doing this from its own debt recovery department. If that fails it will
write off the debt and sell it to a debt purchasing company (DPC) or
use a debt collection agency (DCA) on a commission basis. At the same
time it will receive a payment from an insurance policy which was taken
out when the loan was first authorised, to be triggered upon the lender
Because, on top
of your repayments and on top of your interest you will also (perhaps
unwittingly) have been paying a monthly insurance premium - directly
or indirectly - to be paid when the loan defaults.
Not paid out to
you (though you have paid the premiums directly or indirectly) but paid
to ... you've guessed it ... the bank!
So the bank gets
paid a lump sum by the insurance company whenever a loan defaults and
is written off.
There are also tax
breaks which will benefit the bank when a loan is written off, as this
counts against the bank's tax bill.
Then there is the
tidy little sum that the bank will make when it sells the debt on to
a debt purchasing company. DPCs buy debts, usually in bundles or "job
lots", for mere pennies on the pound. So a £10,000 debt will
typically be bought by a DPC for £400 to £800 or thereabouts.
The DPC will then pursue you, using legal and also possibly illegal
means, for recovery of the whole £10,000.
And if you thought
that the banks were making a good deal by their 92% + interest profit
margins, then just look at what the debt purchasers are making!
If the DPC buys
a bundle of debts for £10,000 it will mean that, at 4%, the total
original value of the debt would be £250,000. It will then try
to recover all of this.
Of course, it won't
be able to, as the debtors will not be in a position to repay what they
owe. They defaulted on the loan in the first place, after all. Their
circumstances may have changed completely since first signing their
credit agreement. All sorts of things could have happened including
unemployment, bankruptcy, divorce, disease, insanity and any number
of personal disasters unique to the individual debtor. So most of the
money will never be able to be collected.
But the DPC will
be able to recover some of this, and so make a healthy return. At only
4% investment it would be difficult not to make a profit! However, in
order to do this the DPC's sales staff will try every dirty trick in
the book to maximise its profits. All its sales staff will be paid (entirely
or mainly) on commission, so everything will be geared up to screw the
unfortunate debtor as much as possible.
They will phone
you up and lead you to believe they are calling from the bank. They
will try to break your will and use all the tricks that salesmen know
about (they are essentially, for the most part, very good telesales
people) to make you part with your money then and there.
is why you should never speak to a DPC on the phone. Always insist they
put everything in writing and politely close the telephone conversation
when they ring you up. The reason for this is that they know that they
can get away with saying things on the phone that they can never get
away with in print. It's also the reason why DPCs are always so keen
on knowing all your telephone numbers, you mobile numbers, work numbers,
Another option for
the bank, other than selling the debt to a DPC, is to hire a debt collection
agency (DCA) who will then use similar tactics to the DPC in trying
to collect the money. In this case, instead of selling the debt outright,
they retain the debt and pass a percentage of the sum thus recovered
by the DCA to that agency.
The effect on the
hapless consumer, who is presumably down on his or her luck in order
to be in this situation in the first place, is much the same whether
a DCA or a DPC is employed. A prolonged period of misery will ensue:
phone calls at all hours of the day and night, threatening letters,
threats to "send the boys round" and people knocking at the
And this is after
the bank has lost none of its own money.
Still troubled by
Anyone who finds
himself or herself in this situation truly enters a world of madness.
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