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- Defaulting on a business loan can have severe consequences, including damage to credit scores, potential seizure of assets and legal action from the lender
- It is important to understand the difference between default and delinquency and to take steps to avoid default whenever possible
- Options for avoiding default include debt rescheduling, debt consolidation loans and communication with the lender to find a solution
Defaulting on a business loan isn’t something anyone wants to do, but it can happen despite your best efforts.
Whether you overborrow or see your company’s income drop, you might find yourself in a situation where you can’t afford to make your loan payments. If that happens, it’s important to know the consequences of default and the steps you can take to avoid it.
What does it mean to go into default?
Going into default on a loan means that you have failed to make payments toward the loan or breached your loan agreement in some other significant way. The loan contract will specify the circumstances under which a loan can be declared in default.
Typically, you default on a loan only after you’ve missed multiple payments, such as three or six months’ worth of payments.
Default vs. delinquency
Going into default on a loan is different from delinquency. Both terms are related to missing payments but describe different severities.
You become delinquent on a loan immediately after missing a single scheduled payment. This will impact your credit score, but you can return your loan to good standing by making up the missed payment plus any late fees.
Default happens after multiple, continuous missed payments. It has a major impact on your credit, and the lender may demand immediate repayment of the loan’s full balance. It is a much more severe situation than delinquency.
What happens when a business defaults on a loan?
Defaulting on a business loan is a bad thing. There are many negative consequences.
For one, your business and potentially personal credit scores will drop significantly. Your lender could also demand full repayment of the loan immediately and apply a penalty interest rate. The lender will then pursue you for repayment in one way or another.
Default on a secured business loan
If your business defaults on a secured loan, the lender has the right to take possession of the asset you used as collateral. For example, if you default on a business loan used to purchase a semi truck, the lender could take your truck and leave you without a way to earn a living.
Default on an unsecured business loan
Unsecured business loans don’t require collateral, but that doesn’t mean the lender won’t pursue you for repayment.
Most lenders require you to sign a personal guarantee. This makes you personally liable for your business debt. If you default on a loan with a personal guarantee, a lender could take you to court to seize personal assets and possibly even add the court costs to your debt.
If your business is formed as a limited liability company (LLC), you typically enjoy protection from having your personal assets seized or being held personally liable for business debt. But signing a personal guarantee can void those protections.
Default on an SBA loan
If you default on an SBA loan, the lender will attempt to seize the collateral you put up to secure the loan. If that’s not enough to cover the debt, it will turn to the SBA to get back the insured portion of the loan. Once the SBA settles with the lender, the SBA will come to you.
You’ll receive an SBA demand letter giving you 60 days to respond. The letter will outline how much you need to repay to the SBA.
If you can’t afford to pay the SBA, you must submit paperwork proving that fact. You can also submit an offer in compromise to ask the SBA to settle for less than you owe. Your offer must include business documents like income and asset statements and details about your personal financial situation.
If you fail to respond to the SBA or the SBA refuses your offer in compromise, it will refer your case to the Treasury Department. At that point, the Treasury could begin garnishing your wages, withholding future tax returns or sue you.
In the 2023 fiscal year, more than half of all SBA 7(a) loans went to existing businesses or those older than 2 years. 20.3 percent went to a new business, 2 years old or less, and 17.8 percent went to startup businesses using the loan to open.
It is risky to lend to a startup or less-established business, which is why many lenders have stringent annual revenue and time in business requirements, and more established businesses often have higher loan approval rates.
What to do before your loan goes into default
Letting a loan go into default is a major problem that should be avoided if at all possible. Before you go into default, consider these options.
Rescheduling or restructuring your debt involves working with your lenders to adjust the terms of your loan to make the loan more affordable.
For example, you could ask your lender to extend the term of your loan. Letting you pay the loan off over a longer period of time will let you reduce the amount you pay each month, which may make the loan more affordable. You could also ask the lender to reduce your interest rate or waive certain fees.
Almost anything is up for negotiation, but remember, there’s no guarantee your lender will be willing to work with you. Restructuring your debt could also damage your credit because you’re no longer following the terms of your original loan.
Debt consolidation loan
You could get a new business loan to consolidate your debt and potentially lower your monthly payment.
For example, if you have two loans, one for $10,000, one for $7,500, and a line of credit with a balance of $2,000, you could apply for a new $20,000 loan and use the proceeds to pay off the balance of all three loans.
This combines the three loans into a single one with one monthly payment. It also lets you adjust the interest rate and payment term of the loans, which could help you lower the monthly payment or save money in the long run.
The drawback of consolidating is that you’re applying for a new loan. If you’re at risk of default, you likely don’t have great credit, which could make it hard to qualify for a new loan. Even if you do find a willing lender, the rate and loan fees on the new loan could be exceedingly high.
The 2022 Small Business Credit Survey by the Federal Reserve Banks found that 28 percent of businesses applied for financing in the previous 12 months to refinance or pay down debt, whereas 65 percent applied for financing to meet operating expenses.
What to do after your loan goes into default
If your loan goes into default, you shouldn’t give up. Working with your lender can help you avoid some of the worst default impacts and keep your business going.
Talk to your lender to let them know about your financial situation and offer to find a mutually agreeable solution. For example, you may ask the lender to work with you to set up a payment plan to get back on track or settle the debt for less than the full amount owed.
If you can come to a debt workout agreement, you may be able to avoid things like liens against the company’s assets or the lender suing you in court.
If at all possible, you should work to avoid defaulting on business loans. Reach out to your lenders sooner rather than later to let them know you’re struggling to make payments. If you do let it get to the point of default, it’s better to work with your lender than against them. Doing so will help you navigate the process while minimizing damage to your business and personal finances.
Frequently asked questions
Typically, no, you can’t get another SBA loan after defaulting. The exception is if the SBA waives this requirement because you had good cause for default.
If the owner signs a personal guarantee, they can be legally forced to pay the company’s debt.
If a small business cannot repay its debt, the lender could attempt to seize the owner or business’s assets or bring the company to court to sue for payment.