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Learn the ramifications of defaulting on a loan and why you should be upfront with your lender about it.
Financing a small business is no small feat and it can be a long and tricky process. However, it’s also a critical element of starting, nurturing and operating a company as profitable growth often depends on borrowing money.
Unfortunately, however, depending on financing can lead some small businesses to financial hardship and loan default. As payments are missed and the possibility of default looms, the type of lender, loan and business factor heavily into the default process.
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Defaulting on a business loan means you’ve failed to make payments or breached other loan agreement terms. Default processes vary by loan agreements and state, The ones outlined below are standard in New York. However, many traditional and alternative lenders not based in New York still operate under New York law or use it as a standard in their loan agreements, regardless of where a business is located.
Experts say business owners who know they’re headed toward a loan default should contact their lender as soon as possible. Depending on the type of lender, it may reduce your interest rates, offer interest-only payment options or restructure your loan terms until your business is back on track.
However, if you don’t reach out beforehand, here’s how the loan default process typically works:
Defaulting on a business loan can have devastating consequences for your business and personal life. “Small business owners need to understand that their business financial decisions can have personal consequences,” cautioned Jay DesMarteau, chief commercial banking officer at Northwest Bank.
Read our overviews of the best business loans and financing options to learn how some top lenders handle defaults.
You may be able to get a business loan with bad credit. Short-term loans, hard money loans and invoice financing are potential options.
Loan defaults are complicated and can include numerous factors, including whether a loan was unsecured, who the lender is, if there was a personal guarantee and more. Consider the following frequently asked questions (FAQs) about defaulting on a business loan.
Both terms indicate a missed payment, but there’s a crucial distinction:
The specific timeframe for a loan to move from delinquency to default varies depending on the lender and loan type.
Lenders are often motivated to work with borrowers facing delinquent and default situations. It’s in their best interest for you to make payments. The company wants its investment back and will be willing to acquire it in the best way possible. “Once the account is in default, the debtor might have more of an ability to resolve the debt because the creditor might be willing to work with them — perhaps toward a settlement or an interest-free payment plan over a duration of time,” Goldenberg said. “Those things could arise, but there’s really no way to predict any particular case.”
Business collateral can be property or other assets the business puts up to help secure a loan. In the event of a default, the lender may seize and liquidate your collateral to recover the outstanding debt. The type of collateral and its value will affect the lender’s recovery options. Whether a lender litigates to seize and liquidate your assets depends largely on the loan agreement terms and the lender’s relationship with you.
Unsecured loans are not backed by any defined collateral from the borrower. DesMarteau said it’s rare for a traditional bank to approve a loan without some form of collateral to secure it. Unsecured loans are more common with alternative or “arm’s length” lenders — lenders with whom you don’t have a personal relationship — than with standard banks and they usually require a personal guarantee from the business owner. If you default on an unsecured business loan, the lender can pursue debt collections, file a lawsuit or obtain a judgment to recover the debt. If the lender obtains a judgment, it may garnish your wages or seize personal assets if a personal guarantee is in place.
A personal guarantee is a legally binding agreement that holds the business owner personally responsible for repaying a loan if the business defaults. It allows the lender to pursue your personal assets, such as your home, savings or other property, to cover the outstanding debt. Business owners are often required to sign a personal guarantee to obtain an unsecured business loan or financing that lacks sufficient collateral.
Defaulting on a loan when you’ve signed a personal guarantee will significantly impact your personal credit score and the default may remain on your credit report for seven to 10 years. If you default and haven’t signed a personal guarantee, only your business’s credit score will be impacted. Defaulting with a personal guarantee also means the lender can pursue your personal assets, such as your home, car or savings, to cover the unpaid loan amount. “With the personal guarantee, that actually puts all the assets of that personal guarantor at risk of being seized if a judgment is obtained against them,” Goldenberg explained. “In other words, it’s a business debt, it’s unsecure, but once it’s defaulted, the creditor has every right to go after that guarantor personally.”
Most business loans require a personal guarantee, especially for small or newer businesses. A personal guarantee can serve an essential purpose in some loan situations — it’s an easy way for a business to get funding when it may not qualify for a loan from a traditional bank. There are some business loans and lines of credit that you can get without a personal guarantee, although they generally have higher interest rates and stricter qualifications.
It is possible to get rid of a personal guarantee by filing for personal bankruptcy and many personal guarantees may qualify for discharge. However, if it is a nondischargeable debt, you cannot use bankruptcy to remove your personal guarantee. On the other hand, filing for business bankruptcy will shift the responsibility for paying back the loan from your business to you personally and the lender will look to you and your personal assets for the money.
When a contract with a personal guarantee is breached, the lender can go directly to the guarantors and is not required to exhaust other options against your business before doing so. As such, it’s vital to understand the ramifications and the agreement structure before signing anything with a lender. Goldenberg said that some merchant cash advance (MCA) companies, which are lenders that provide cash advances against credit card receivables, may require borrowers to sign confessions of judgment (COJ). These COJs allow the lender to expedite the legal process, freezing assets or placing liens against personal assets immediately after default is triggered. “Where you borrow your money can have a huge impact on what happens if you can’t keep up with the agreed-upon payments,” Goldenberg said. “To borrow from an MCA that’s going to file a confession of judgment on you a week after you’ve missed your first payment and then attempt to freeze all of your bank accounts, those are remedies that really would take commercial banks three months, six months, a year [or] maybe longer to get to that point.”
The risks of a personal guarantee can be significant. If your business falls into financial difficulty, then you are personally responsible for repaying the loan.
Small Business Administration (SBA) loans are government-backed loans. This is a program for businesses that may not otherwise qualify for loans with banks or alternative lenders. If you default on an SBA loan, you’re still on the hook to cover the lender’s loss. DesMarteau said that SBA loans almost always require collateral, which can be liquidated in the event of default. “Because of these more favorable terms … the SBA requires the business owner to pledge all available collateral, often including a person’s residence. If the business owner defaults, the [lender] might force a liquidation of all collateral to repay the debt.” The SBA itself is not a lender; it only guarantees up to 85 percent of the loan amount to lenders who give SBA loans. If you default on an SBA loan, you will deal directly with your lender, not the SBA. The lender will call in the SBA guarantee only if its efforts to collect payment from you fail. Lenders’ efforts generally include contacting borrowers after a delinquency period and possibly charging a late fee. Different lenders have varying policies on how they treat late payments. A lender might allow a borrower to restructure the loan or make interest-only payments for a certain period. If a lender calls on the SBA guarantee and the federal government takes a loss on the loan, the government may take additional measures to recover the loss, such as garnishing the borrower’s wages or freezing their bank account.
The best thing you can do as a borrower is contact your lender when you start missing payments. If you’re transparent with them, most lenders will work with you in some way. If you’re worried you may default on a loan, here are some steps you can take.
The National Foundation for Credit Counseling (NFCC) provides small business owners and individuals with free legal counseling and resources. It can be a great place to start if you’re looking for more guidance on a loan dispute.
Rodney Ramcharan, a finance and business economics professor at the University of Southern California Marshall School of Business, emphasized that your lender will dictate much of your default process.
“If you’re borrowing from a bank that’s strictly arm’s-length, so it only uses data to score and evaluate these loans, then your ability to get some kind of dispensation from the bank could be much more constrained than if you are lending from a relationship-based lender who … might be more inclined to use soft information to not foreclose upon this loan,” Ramcharan explained.
Partnering with traditional or local banks gives you a greater chance of working through issues as they arise. Goldenberg said arm’s-length lenders, such as MCAs, have different funding practices and may be in a position where their primary concern is just getting their money back.
“When you have a bank, they sort of understand this business on a much larger scale, [knowing that] there’s always going to be some underperforming accounts,” Goldenberg noted. “With MCAs, you might have an individual person that funded that loan or maybe a small group of private investors that put down money toward funding a particular company … they’re not a large corporation.”
That means the stakes for working with arm’s-length lenders are different from traditional or local banks and it’s critical to understand this distinction as a borrower.
Some lenders, including those for SBA loans, may work with you on an offer in compromise, which allows you to settle your loan debt for less than the full amount owed. An offer in compromise is an option for borrowers who cannot repay the entire amount or if doing so would create undue financial hardship. Similarly, the IRS has an offer in compromise option for settling tax debt for less than the total liability.
If you pursue this option for either loan or tax debt, it may be helpful to contact a business attorney or tax professional who specializes in debt settlement to help you navigate the process.
Consider options like loan modification or business loan refinancing, which involves renegotiating the terms of your loan agreement with your lender. Assess your financial situation, understand the loan you want to restructure and determine a realistic repayment plan. Clearly explain your financial difficulties and propose potential solutions like extending the repayment period or lowering the interest rate. Be prepared to negotiate and be sure to get any agreements in writing.
Legal and financial professionals can help you avoid defaulting on a loan — or help guide you through the process, if necessary. For example, a business attorney can help ensure you understand a loan agreement’s intricacies, negotiate favorable terms in case of financial hardship and comply with relevant laws. A financial professional, including a certified public accountant (CPA), can help you manage your finances and stay on track.
Legal and financial professional guidance can help you take proactive steps to safeguard your business, minimize default risks and increase the chances of a successful loan journey.
The best strategy for maintaining a healthy, financially stable business is to maintain good cash flow and follow meticulous accounting practices, using the best accounting software and financial guidance.
DesMarteau stressed that keeping business and personal finances mutually exclusive is an essential first step. “Muddling finances can cause SBOs [small business owners] to miss any warning signs that their business finances aren’t on track or make it easier to ‘borrow’ money from the business to pay personal needs, which can cause them to slip up on a payment or overdraft accounts,” DesMarteau explained.
Sometimes, default is unavoidable. However, it is crucial to work with your lender and use any available resources. “Most lenders would appreciate a forthcoming debtor and might actually reciprocate with courtesy to a debtor who is acting genuinely, sincerely and proactively to try to come to reasonable terms,” Goldenberg said.
Mike Berner and Jamie Johnson contributed to this article. Source interviews were conducted for a previous version of this article.
