The majority of America’s small businesses use financing. Given the unpredictable nature of entrepreneurship, some of them, unfortunately, find themselves unable to fulfill their financial obligations. In some cases, they’re late on payments. Other times the payments are 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 when you default on a loan? 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. 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 often must 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 able 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
Simply missing loan payments will hurt your business credit score, so a default makes an even more substantial impact. Lenders will likely regard you as a higher risk, 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 one 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 one 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.