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Business owner contemplating defaultingTaking out a business loan can help you get your startup off the ground or scale an existing business. But you could run into problems if you find yourself unable to repay your lender. A business loan default isn’t an ideal situation to be in, and there are several ways it can affect you financially. Knowing what to do – and what not to do – when taking out business loans can help you avoid that situation.

Business Loan Default, Definition

Being in default on a business loan or any other type of loan means the loan has gone unpaid for a set period of time. When you’re considered to be in default can depend on the lender. For example, you might be considered in default after the first missed payment or your lender might let six months of missed payments go by first.

In most cases, the lender will try to give you an opportunity to make up missed or late payments before putting the loan in default. That’s known as forbearance. When a business loan default happens, that’s money lost for the lender. So they may give you some leeway so you have a chance to catch up to minimize potential losses.

Consequences of Business Loan Default

"Loan Default" in writing

The most immediate impacts of defaulting on a business loan can depend on what type of loan is involved and how your business is structured.

Initially, you can expect to receive phone calls and letters from your lender asking you to pay what’s owed. If that doesn’t get results because you don’t respond or you’re not able to pay, the lender can turn your account over to a debt collector. If a defaulted loan is sold to a debt collection agency, you now owe the debt collector, not the original lender. Throughout all of this, interest, penalties and fees can be added on to the loan balance.

Here’s what can happen next:

  • You can be personally sued. If you operate as a sole proprietor or you signed a personal guarantee for a business loan, you could be sued by the lender or the debt collector. If you lose in court, you could be ordered to pay the amount owed along with the lender or debt collector’s legal fees.
  • Your personal assets could be attached. Signing a personal guarantee means that you agree to be personally responsible for a business debt. If you sign a guarantee and are sued, the lender can come after your personal assets as repayment for the loan.
  • You could lose your collateral. Secured business loans require collateral, which typically means pledging business assets. Even if you got a business loan without a personal guarantee, your business assets could still be at risk if you default.
  • Your credit score can suffer. Your personal and business credit scores can take a hit following a business loan default, depending on how the loan is reported to the credit bureaus. If you used your Social Security number to apply for the loan or signed a personal guarantee, a default and a judgment could end up on both your personal and business credit history.
  • Your bank accounts or tax refunds could be garnished. If there are no physical assets a lender can seize as part of a lawsuit to collect a debt, they could come after your business or personal bank accounts instead. And if you default on an SBA loan, the federal government can offset your tax refund for repayment.
  • Getting new loans or lines of credit can be more difficult. When defaulting on a business loan damages your credit, that can make you appear riskier to lenders going forward. That could make it more challenging to get approved for new loans or lines of credit when you need business capital. You may also have a harder time getting your vendors to extend credit to you as well.

Avoiding a Business Loan Default

There are several things you can do to minimize your odds of defaulting on a business loan, starting with being selective about borrowing. Before you take out a new business loan, you should consider the fees and interest rates as well as the monthly payment to make sure that it’s sustainable for your cash flow.

If you’ve already taken out a business loan and you’re worried about defaulting, the most important thing you can do is stay in touch with your lender. Your lender may be able to offer you options to stay current on the loan. For instance, they might be willing to allow you to put payments in forbearance temporarily if you’re experiencing a financial hardship.

You can also explore other options, such as loan refinancing. Refinancing a business loan to a lower interest rate could also result in a lower monthly payment. If your payments are more manageable, then the odds of defaulting may go down.

What to Do If You’ve Defaulted

Business owners talking to their lender

If you’ve already fallen behind on a business loan, the worst thing you can do is ignore the situation. Reach out to your lenders or to the debt collection agency handling the loan if it’s already been sold to discuss options for repayment. You may be able to work out a new payment plan. Or a debt collector might be willing to discuss a settlement in which you pay less than what’s owed to close out the debt.

These solutions may not be ideal but they can help you avoid a lawsuit and curb the damage to your credit score. If you’re in a situation where you absolutely can’t afford to pay the loan and your business is in danger of going under, then you may need to consider a more drastic alternative.

Filing bankruptcy could help you restructure the debt or eliminate it completely, depending on how your business is structured. If you’re a sole proprietor, for instance, you and the business are essentially the same from a financial perspective. So if you have little to no assets and no way to repay the loan, Chapter 7 could wipe the debt out so you can start fresh.

On the other hand, if you operate as a corporation or LLC, then Chapter 11 might make more sense. A Chapter 11 bankruptcy filing can help you restructure your business debt and pay it off without having to close your doors or sacrifice business assets. Talking to a bankruptcy attorney or credit counselor can help you compare all of the options for managing a defaulted business loan.

The Bottom Line

Defaulting on a business loan is hardly an ideal situation and it can have lasting impacts on your business’s financials. And in some cases, it can also affect your personal financial situation. Fortunately, there are options for dealing with a business loan default so that you can get your business back on the right track.

Tips for Small Business Owners

  • Consider talking to a financial advisor who specializes in working with small business owners. If you don’t have an advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor tool can match you with up to three local financial advisors, and you can choose the one who best fits your needs. If you’re ready, get started now.
  • If your small business is struggling to pay its debts and your creditors are threatening to take your assets, bankruptcy may be an option. It’s important to understand the differences between the various types of bankruptcy available to small business owners.

Photo credit: ©iStock.com/ljubaphoto, ©iStock.com/Andrii Dodonov, ©iStock.com/picture

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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