The COVID-19 pandemic has unleashed an absolutely brutal time for America’s entrepreneurs. Supply chains have been disrupted, shoppers have changed their spending habits, and operation costs have increased. It’s been a perfect storm that’s impacted all but a small portion of our nation’s businesses.
As the pandemic stretches into another year, many of these problems show no sign of letting up. In fact, a commonly referenced study has suggested that 800 small businesses have been closing each day. According to other research, that number might be as high as 1,500 small businesses.
It’s no wonder many small business owners are facing the prospect of business loan default. Even if they’ve never dealt with this challenge before, they’re now wondering, “What happens when you default on a loan?”
A Ray of Sunshine Amidst the Gloom
Congress has provided some much-needed good news for small businesses in the form of $900 billion in coronavirus relief package. The funding includes $284 billion for another round of Paycheck Protection Program (PPP) loans. Those who qualify for these loans can receive as much as $2 million, which is meant for covering 2.5 months of payroll.
As long as you use at least 60% of the loan’s funds on payroll, the loan can be forgiven. This is a game-changer, as it provides a potentially cost-free boost to small business finances.
If your business is applying for a PPP loan for the first time, you will likely get priority in the review process. And those who already received funding might still qualify for a follow-up. Better yet, the smallest of businesses will get more opportunities that weren’t available the first time around.
“Of the $285 billion set aside for PPP, $12 billion is designated specifically for minority-owned businesses and businesses in underserved communities,” says Brock Blake, Lendio’s CEO and cofounder. “During the first rounds of PPP, it is well documented that many lenders prioritized large loans due to the program’s reimbursement economics. In this round, Congress increased the reimbursement on loans less than $50,000 so that lenders have incentive to prioritize the smallest of small businesses. To me, this may be the most important change; I’m glad to see America’s underserved and smallest businesses finally receive the attention they need during these critical moments of survival.”
With the improvements made to this new round of PPP loans, there’s hope that a wider range of businesses will receive funds to sustain them through the tail end of the pandemic. But PPP loans aren’t a magical cure for all the struggles our nation’s businesses are facing. The fact is that many businesses will still need to navigate the threat of being unable to pay for a business loan.
What Happens When You Default on a Loan
Being unable to make payments on a business loan is not a new phenomenon, and long before the pandemic, scores of hard-working business owners found themselves in situations where they couldn’t fulfill their financial obligations. In some cases, they were late on payments. Other times the payments were missed altogether. Some lenders are more tolerant of delinquency than others, but at a certain point, late and missed payments result in a default.
So what happens if you default? That depends, as the consequences of business loan default vary depending on the way you guaranteed the financing. Let’s look at 3 possibilities:
1. Unsecured Loans
This type of loan doesn’t require any type of collateral from the borrower in order to secure the funds (hence the name). Lenders are understandably reluctant to offer these loans as they involve higher risk. To compensate for this lack of collateral, unsecured loans usually have lower dollar amounts, higher interest rates, and shorter repayment terms.
Additionally, lenders usually require you to make a personal guarantee to receive an unsecured loan. While this isn’t technically collateral, there’s a similar impact if you default on an unsecured loan. The lender will come after your personal assets to recoup the money involved with the financing.
2. Secured Loans
While unsecured loans often need a personal guarantee, lenders take it to a more specific level with secured loans—you’ll be asked to provide collateral that meets or exceeds the value of the loan. Popular examples of collateral include homes, boats, vehicles, real estate, inventory, machinery, and accounts receivables.
In the case of a default, some lenders may be willing to work with you to find a solution. But if you’re ultimately unable to meet your payment obligations, the promised collateral will become the property of the lender. The lender will need to put time and effort into selling the asset before they actually get paid, which is why collateral must often be worth more than the actual value of the loan.
3. Secured SBA Loans
If you’re unable to pay a business loan that you acquired through the Small Business Administration (SBA), your first interactions will be with the lender who funded the loan. They’ll begin the collection process outlined in the loan agreement, which usually includes the lender taking possession of any collateral attached to the loan.
At this point, the lender submits a claim to the SBA. Because the agency will have guaranteed a portion of your loan, they’ll pay the lender that amount.
The remaining debt is then transferred to the SBA. The agency will request payment from you to cover their expenses. If you’re financially able, you can resolve the situation immediately. You can also make an offer in compromise, where you explain any extenuating circumstances and request that the SBA lets you settle the debt with a smaller payment than is officially required.
Assuming the SBA accepts your payment or offer, the case will be closed. When a resolution can’t be found, however, the agency submits your account to collections officials at the Treasury Department. This phase is where things can get serious, as the Treasury Department has the authority to garnish wages and take other actions to get the money they are owed.
Additional Impacts of a Business Loan Default
The simple act of missing loan payments hurts your business credit score, so a default makes an even more substantial impact. Lenders will likely regard you as a higher risk in the future, leading to higher interest rates and shorter repayment terms on future financing.
Your personal credit score might also be affected, depending on how you set up your business. Some structures offer liability protection to owners. For example, a limited liability company (LLC) provides shelter from defaults. Sole proprietorships, on the other hand, leave the owner completely responsible for such failures.
“Of all the decisions you make when starting a business, probably the most important 1 relating to taxes is the type of legal structure you select for your company,” says a finance guide from Entrepreneur. “Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face, and your ability to raise money.”
While no small business owner ever applies for financing with the intent of defaulting, it’s wise to consider that possibility as you set up your business. Your strategy at the onset can potentially save a lot of headaches and financial losses down the road.
The Importance of Communication
Because your business structure is so relevant if you default on a loan, it’s crucial that you speak with any partners about this matter before you set up your business. The discussions you have early on will help ensure you’re on the same page and will be unified in the case of financial difficulties.
When seeking small business financing, you’ll also need to talk to the lender about how they handle late payments and what would happen if you were to find yourself unable to make consistent payments. Lenders aren’t nonprofits and they obviously need to be paid, but it’s possible to find 1 that is more willing to work with you to find solutions before things progress to the default stage.
If you acquire financing and then find yourself in a situation where repayment isn’t possible, you’ll need to have another candid conversation with the lender. Before picking up the phone to call them, take the time to put a plan in place. For example, you might propose making lower payments for a time. The important thing is that you have a strategy in mind so that you can give the lender confidence that you’re committed to fulfilling your obligations. Hopefully, this plan will encourage them to be more keen to work with you.
For those business owners who are currently struggling to cover all their business expenses, just know that you are not alone. Talk to your lender and explain your situation. Seek a solution that works for everyone. These are unbelievably difficult times for America’s small businesses, but there are still good people out there who want to help you.
The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice. All information, content, and materials available in this post are for general informational purposes only. Readers of this post should contact their attorney, business advisor, or tax advisor to obtain advice with respect to any particular matter.