What Happens If You Can’t Repay Your SBA Loan?

How SBA loan default and forgiveness works

If you are a small business owner in danger of defaulting on your SBA loan, here’s everything you should know:

1. Talk to your bank about your loan payments (not the SBA).

Even though your loan is called an SBA loan, your lender makes day-to-day servicing decisions, not the SBA. If you’re struggling to make payments, you’ll need to plead your case to your bank. 

A lender can typically offer two types of assistance: a modification or a deferment.

• Loan modification: A modification most frequently comes in the form of a term extension, which pushes back the loan’s maturity date. If your loan now matures in 10 years instead of five, you’ll see a significant reduction in monthly payments. 
• Deferment: A loan deferment is a more short-term solution. Deferments are usually available for periods of three to six months or occasionally up to 12. Deferments are intended for short-term issues, like a broken water pipe that shuts you down for a month or a significant order that uses up all your working capital.

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When speaking with your bank about a loan modification or deferment, remember that you catch more flies with honey than with vinegar. In other words, be nice. It helps. While there are times when you should push back on the lender or take an aggressive approach, that shouldn’t be your default approach. Be courteous, return calls promptly and send the lender the information it needs on time. Making your lender’s life easier can never hurt. 

2. The SBA will consider settlements.

Modifications and deferments are great for blips and hiccups, but when a business is bleeding cash with no end in sight, a deferment is akin to a Band-Aid on a broken leg – it’s not enough. In many cases, the only way to solve the problem is to shut down the business. That’s never an easy decision, but often it can be the right one.

Once your business closes, ideally, that would be the end of it. Unfortunately, it’s not. The overwhelming majority of SBA loans require personal guarantees, so even if your business is closed, the onus is on you to make good on the debt.

While the bad news is that you could potentially be on the hook for a significant sum of cash, the good news is that the government understands it can’t get blood from a stone. That’s why the SBA is willing to consider settlements, a process known as “offer in compromise” (OIC).

It’s important to note that an OIC is not a right and not everyone is eligible. A lengthy list of factors determines whether the SBA will consider some level of forgiveness, but in short, the borrower must demonstrate financial hardship and an inability to repay the debt over a reasonable period.

3. Settlements are based on a few broad concepts.

A settlement should bear a reasonable relationship to the amount recoverable through enforced collection. Essentially, the SBA compares your offer to the amount it thinks it could get if it sues you. Can it levy your bank account or garnish your wages? If so, keep that in mind when devising your offer. It helps if you don’t have assets that can be garnished, but that doesn’t mean you are off the hook.

Don’t lean too much on the point above. You can’t thumb your nose at the lender because all your assets are sitting in a 401(k) retirement account. To qualify for a settlement, you must demonstrate financial hardship and a lack of ability to pay. This means that even though the SBA can’t force you to crack open your piggy bank, you may need to do it yourself if you hope to settle.

The amount you settle for will be directly tied to your personal financial situation. No arbitrary percentage will make the bank and the SBA say yes or no to an offer. They will require full financial disclosure, including a special personal financial statement (SBA Form 770), tax returns and bank statements.

If you fail to work out a deal with your lender or the SBA, the U.S. Department of the Treasury will base its settlements on an arbitrary percentage. Also, settlements are based on what you can afford, not what will be convenient for you, so don’t expect it to be easy or cheap. 

4. Settlements come with strings attached.

While settling your debt is a positive thing for your finances and psyche, it’s not all rainbows and unicorns. These stipulations are worth knowing about:

• SBA debt forgiveness may be taxable. If a lender forgives a portion of the debt, you may receive a 1099 for that amount. The SBA also sometimes reports settlements to the credit bureaus. You may be able to dispute it on the basis that it was not a consumer debt.
• You’ll land on a government blocklist. The government maintains a list of borrowers who have defaulted on various obligations called CAIVRS (Credit Alert Verification Reporting System).

What happens if you default on an SBA loan?

If you don’t respond to your demand letter, the SBA sends your debt to the Treasury Department for collections under the Treasury Offset Program. 

If your debt goes to the Treasury Department, there are several ways it can collect your outstanding debt:

• Wage garnishment
• Social Security benefits garnishment (or other retirement benefits)
• Withholding federal income tax refunds
• Offsetting your bank account(s)

Since your loan belongs to the federal government, there’s no statute of limitations on how long your loan can be in collections, and the government doesn’t need a judgment to institute garnishment. You might be able to settle with the Treasury Department, but it’s not likely. And if you do, it’ll be for much more than what the SBA would have settled for.

What are the alternatives to defaulting on your SBA loan? 

Defaulting on your SBA loan should be a last resort. It often means your business is in grave danger. Here are some ways to avoid the problem: 

• Increase cash flow. As soon as you start struggling to make your loan payments, identify ways to improve your cash flow and reduce business expenses. For example, try renegotiating with vendors and reducing the shifts hourly employees work. You can also lower the salary you draw from your business to raise cash. 
• Sell unused assets. Consider selling off equipment, underutilized vehicles or real estate to help pay your debt.
• Consolidate loans. If applicable, see about consolidating existing loans to get better terms and free up cash.
• Sell all or part of the business. A sad but realistic option may be selling the business and using the cash to pay off the debt. Although a business that is struggling financially is unlikely to get top dollar, it might be worth more to a competitor or a company looking to enter your market. Alternatively, you might be able to sell part of your business, like a product line you haven’t been able to maximize, some of your intellectual property or access to your customer list. 

Consider alternative debt

If you’re sure you’ll receive sufficient revenue in the short term (within the year), consider taking on a bridge loan or getting cash from credit card receivables financing or invoice factoring. You might also want to look into refinancing your SBA loan with an alternative lender with more flexible repayment terms.

While nobody takes out an SBA loan expecting their business to fail, it happens every day. Is it a fun situation to navigate? Decidedly not. But the good news is that if your business begins to struggle and you’re contemplating shutting your doors, settling your SBA loan might be an option.

Jennifer Dublino contributed to this article.