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. The debt purchasing company will spend the next few months or even years making your life Hell in the process, using tactics which sometimes involve breaking the law such as the underhand and dodgy antics you can read about everywhere on the financial consumer forums as well as in the press and on TV.
The bank knows the DPC will do this, but they don’t care. By this time they will be quids in.
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 because they can get away with it. 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.
“Banks 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 on credit card accounts have since been declared as illegal, and thousands of people have benefitted from successfully claiming back all their penalty charges from their bank credit card accounts (although the OFT have since, incredulously, ruled that the penalty charges on bank current accounts are not illegal and have waved the banks through on this – to the disgust of everyone but the banks).
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? 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.
Firstly, remember 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 previous page on Fractional Reserve Banking). 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.
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 it still expects you to pay back the other 92%. And it knows that the current law will back it up.
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.
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 on its profits.
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, sometimes individually but more usually in bundles, for mere pennies on the pound. So a £10,000 debt will typically be bought by a DPC for £400. The DPC may then pursue you, using both legal and 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.
(Incidentally, this 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, etc.)
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. (You should note that, in cases where the debtor account is sold outright, you should by law receive a letter called a Letter of Assignment telling you this and giving you all the relevant details; some don’t bother to do this, though, it seems.)
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 door.
And this is after the bank has lost none of its own money.
Still troubled by your conscience?