If you’re a small business owner, you’ve likely considered debt financing to fund your company’s growth or to set up an emergency fund. You may already have a fixed-term loan or business line of credit.
However, you may have wondered what happens if you default on a business loan. While it’s not something that most business owners believe will happen when they initially take out a loan, it is important to consider if something should happen and the profitability of your company takes a nosedive.
What Does it Mean to Default on a Loan?
Defaulting on a loan essentially means that a company regularly makes late payments or misses payments altogether. In a loan contract, there will be specific language that indicates when a lender can officially declare that a borrower has defaulted on a loan.
If the borrower meets the requirements for default according to the loan agreement, the lender will have the right to declare that the borrower has defaulted and take actions to recoup the monies lent.
What Happens if You Default on a Business Loan?
If your business loan goes into default, the lender will most likely begin to take legal action. This action will occur after a set period of regularly paying late or missing payments altogether.
Typically, the time period that must pass before a loan can be declared as defaulted is six months, but this may vary depending on the contract that the lender and borrower agree to.
The consequences of defaulting on the loan will vary according to the type of loan that was withdrawn, the type of legal entity that the business operates as, and whether the loan was guaranteed in any way by the owner of the business.
Defaulting on a Secured Loan
If the business defaults on a secured loan, the lender will have the right to take into possession any property that was declared as collateral. Items typically declared as collateral can include real estate, homes, machinery, equipment, boats, or other items of significant value.
Such items are typically worth more than the value of the loan itself. The items used as collateral will be possessed by the lender and sold to recoup the value of the loan, which will take time and effort on their part.
Defaulting on an Unsecured Loan
An unsecured loan does not require any collateral when you obtain it. Hence, lenders will typically only issue unsecured loans for a smaller overall value than a secured loan. The unsecured loan will typically have a shorter repayment term length and a higher interest rate than a secured loan would.
Do I Have to Personally Guarantee a Business Loan?
While there may be no property that the lender can seize in the event of default on an unsecured loan, they usually do require a personal guarantee from the borrower at the inception of the loan. Any personal guarantee business loan default can affect your credit rating.
SBA Loan Default
If your company defaults on a Small Business Association (SBA) loan, the collection process will first begin with the lender. They will take possession of any collateral associated with the loan.
Afterward, they will submit a claim to the SBA to receive payment for the portion of the loan that the SBA guaranteed. The SBA will pay the lender for the portion guaranteed, and the remainder of the loan will be transferred to the SBA.
Do You Have to Pay Back SBA Loans?
At this point, the SBA will pursue you for the remaining balance of the loan and for the cost of their expenses. You may attempt to settle the debt for a smaller amount by explaining your extenuating circumstances when this happens.
If the SBA accepts your offer, you can make the payment, and the case will be closed. If they do not, then your case will be passed to the Treasury Department, which will result in further collection activities that can grow in severity.
How Defaulting Affects Your Business Credit
Defaulting on a loan is never good for anyone, personally or business-wise. You should make every attempt to repay your loan in a timely manner.
If you are not able to, try to work with your lender to lower your monthly payments or to pursue another strategy that they agree to. The lender may be willing to work with you on a strategy if you contact them early enough.
If your business does default on the loan, it can severely impact your business credit. Your company may be unable to obtain future financing for a significant period of time, and any future loans will likely have high interest rates and other undesirable terms.
Can Business Debt Affect Personal Credit?
Whether defaulting on a business loan affects your personal credit depends on your company’s entity structure and if you personally guaranteed the loan in any way.
Sole proprietorships and partnerships that default on a business loan will see an impact on their personal credit since, by definition, their companies are structured in a manner where they are personally responsible for any company debt.
They will have applied for the loan based on their personal credit history that is tied to their Social Security number. This approach can have a devastating effect on their personal finances and credit history.
If the company was formed as a Limited Liability Company (LLC), S-Corporation, or C-Corporation, the owners might not see an impact to their personal credit history unless they have applied for the loan in their own name or have given some other personal guarantee to the lender.
Steps to Avoid Loan Default
If your company is unable to pay a business loan, it is important to take action immediately.
1. Contact Your Lender and Let them Know the Situation
Do this as soon as possible so that they may attempt to work with you to find a resolution and avoid default. Options they may offer can include restructuring payments or pausing payments temporarily.
2. Consider Refinancing the Loan
If it is early enough, you may be able to find another lender who can issue a new loan that you can use to pay the old one off. This tactic can result in lower monthly payments, a longer term for repayment, or other potential advantages.
3. Pay What You Can
Do as much as you can to avoid default. Even if you can’t make the entire monthly payment, pay as much as you are able to the lender, so they see that you are attempting to stay within the terms of the loan agreement.
4. Talk to a Debt Counselor
A debt counselor may be able to give you advice to assist you with repaying the loan or work directly with the lender on your behalf to set up a repayment plan that both parties can agree to.
5. Talk to a Bankruptcy Lawyer
If all else fails, talk to a bankruptcy lawyer for additional advice and to find out whether bankruptcy would be a potential option for your business (or yourself).
How to Recover from Loan Default
Recovering from loan default will take time and effort. You may want to talk with an accountant, debt counselor, or certified financial planner to gain advice on how to speed the recovery process forward.
You will be unlikely to gain debt financing at agreeable terms, so you will need to manage your finances very carefully to ensure that your business is able to function and continue to grow.