Taking on debt is a common way to finance a business, but it can be risky. If you can't repay your small business loan, you may end up defaulting on it. Defaulting on a business loan can have a variety of negative consequences, from loss of personal assets to bankruptcy.
Here we look at what happens if you default on your business loan repayments and give you tips on how to avoid the situation altogether.
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What is a business loan default?
A business loan goes into default if you repeatedly violate the legal terms of the loan agreement. Defaulting on a loan means continually missing payments, failing to make payments, and failing to come to a resolution with the lender. At this point, the lender has decided that you won't repay your debt.
Business loan defaults and delinquencies
Before a business loan goes into default, it is considered delinquent. Generally, a loan is considered delinquent when it is late in making a payment, but this can vary depending on the lender and your specific business loan agreement.
Lenders may charge you a late fee if you miss a payment, but they may also give you a grace period of a few days or weeks during which you can avoid the fee if you make your payment within that period.
If you make a payment, your loan will be cleared of delinquency. On the other hand, if you continue to miss payments, your loan may go into default.
What happens if you default on your small business loan repayments?
If you start to fall behind on your business loan payments, your lender will likely contact you about the arrears and try to work things out.
If you don't respond and your loan goes into default, the lender will use all available means to try to collect on the debt. This process can have the following consequences:
Loss of collateral
If you default on your repayments on a secured business loan, the lender can repossess the collateral to cover their losses. For example, if you take out an equipment loan to buy a new tractor and that tractor is collateral for the loan, the lender can seize the equipment to recoup their funds if you default.
While an unsecured business loan doesn't require you to provide specific collateral, many lenders will put up a Uniform Commercial Code lien against your business assets, which allows the lender to use your business assets to recoup losses if you default on the loan.
Loss of personal assets
Most lenders require you to sign a personal guarantee when taking out a business loan. A personal guarantee gives the lender the right to seize your personal assets to repay the debt in the event of default.
If you default on repayments on an unsecured business loan, the lender will likely use this method to recover its losses (or its security interest, if one has been created), whereas with a secured loan, the lender will pledge the collateral first and only resort to additional methods if the debt isn't repaid in full.
Lenders file lawsuits
If you can't or refuse to use your business or personal assets to repay your debt, the lender can take legal action. If the lender sues, you'll be responsible for paying the outstanding loan balance, plus interest, fees, and additional penalties. You may also have to pay court costs and attorney's fees.
Through this legal process, the court will determine the appropriate method of repayment, which may include allowing the lender to garnish your paycheck, tax refunds, or personal bank accounts to repay the debt.
Damaging your credibility
Missing business loan payments can have a significant impact on your business (and in some cases, your personal) credit score.
Lenders may report late payments, collections, and judgments (the result of a lawsuit in which a lender has to sue you to collect a debt) to commercial credit reporting agencies, all of which can have a negative impact on your business credit score.
Collections and judgments remain on your report for just under seven years. Most personal accounts don't report a late payment until a payment is 30 days late, but business accounts will report even a one-day late payment.
It's important to be aware that even if a lender normally only reports to commercial credit bureaus, they may also report your default to consumer credit bureaus. This damage to your business or personal credit could make it harder to obtain financing.
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How to avoid defaulting on a business loan
Recovering financially from defaulting on a business loan can be difficult. If you're behind on payments or don't expect to be able to repay your loan, consider these strategies:
Check your business's financial health
By reviewing your financial situation, you may be able to identify solutions that will allow you to continue making loan payments. For example, look at your cash flow statement to see if you have enough funds to make loan payments at any given time.
If your cash flow is inadequate, you can reevaluate your expenses to determine if there are areas where you can cut costs.
On the other hand, if multiple loans with high interest rates are hurting your cash flow, consider a business debt consolidation to combine these loans into one new loan, ideally with a lower interest rate and better terms.
Talk to your lender
Ultimately, lenders want you to pay back your debt, so if you're having trouble making payments, talk to a small business lender before you default.
If you contact your lender and are open and honest about your difficulties, they will be more likely to try to find a solution, such as:
Defer payments for a certain period of time.
Adjust the terms of your loan to make payments more manageable.
Lower interest rates.
For a set period of time, you can pay only the interest on the loan.
Work with experts
If you're struggling financially, it may be helpful to work with a business professional, such as a CPA or lawyer, who can review your situation and provide personalized advice on how to manage your payments and avoid defaulting.
A business lawyer can also help you negotiate a settlement with lenders and debt collection agencies, and assist with the legal process (if necessary).
To access low-cost or free financial and legal advice, contact your local Small Business Development Center or similar business service organization, such as SCORE.
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FAQ
What percentage of small business loans default?
According to the latest Equifax Small Business Default Index, the default rate for business loans is 2.56%.
What happens to small business loans if a business fails?
If your business fails, you will still be responsible for repaying the loan. As with a default, if you can't repay, the lender may seize your collateral or personal assets to recover their losses.
What happens if you default on a business loan that has a personal guarantee?
If you sign a personal guarantee and then default on your business loan, the lender has the right to claim your personal assets to repay the debt. If you don't have enough assets to repay the debt or refuse to cooperate with the lender, the lender can also sue you in court for a judgment.
What percentage of small business loans default?
According to the latest Equifax Small Business Default Index, the default rate for business loans is 2.56%.
What happens to small business loans if a business fails?
If your business fails, you will still be responsible for repaying the loan. As with a default, if you can't repay, the lender may seize your collateral or personal assets to recover their losses.
What happens if you default on a business loan that has a personal guarantee?
If you sign a personal guarantee and then default on your business loan, the lender has the right to claim your personal assets to repay the debt. If you don't have enough assets to repay the debt or refuse to cooperate with the lender, the lender can also sue you in court for a judgment.