A lot of small businesses might require a loan for many reasons with the expectation of paying it back on time. However, even the most flourishing business can hit sudden financial issues. At times, defaulting on a loan cannot be avoided. However, if you do your research to understand the procedures and conditions, you might be able to dodge the difficulties you are likely to face.
What Does Defaulting on a Business Loan Mean?
A loan default occurs when you are not able to or willing to repay the debts you owe to creditors. In the event that an individual is unable to pay their monthly installments, they default on the loan. Likewise, if a business issues bonds and it can’t make coupon installments to its bondholders, the business is in default on the bonds.
When an individual, a business or even a country defaults on a loan, the loan creditor has some authority to recover the assets, depending on the type of security involved. For instance, in the case of a simple loan default, the mortgage creditor can recover the debt by seizing and selling the collateral property.
Similarly, if a business goes into bankruptcy, all of its loans have defaulted automatically. In this case, lenders can take legal action which can result in the liquidation of the assets of the debtors. These assets may include business properties, stocks, and vehicles.
Types of Loans
When your business loan goes into default, creditors try to collect all the debt you. Their actions depend on the type of loan you borrowed. There are two types of loans:
A secured loan means you have guaranteed your repayment of the loan by offering a collateral to the lender. Collateral are assets that you can declare as security for the repayment of a loan. This may include vehicles, properties, and other assets. The lender can acquire and sell off your collateral to recover the debt you owe them in case you are unable to repay the loan.
Unsecured loans are offered on the basis of your credit score and repayment is not guaranteed through collateral. In case of failure of repayment, the loans are turned over to debt collection agencies that acquire the amount you owe to the lenders by garnishing your bank accounts or seizing your personal assets. These types of loans are riskier for lenders since there is no collateral.
What Happens When You Default on a Loan?
As soon as you start missing installments, your lenders will contact you to know the reason for this. Some lenders start taking action after a month of your missed installment, whereas others might wait a few months before moving ahead. As more installments are missed, the likelihood of defaulting lingers. It’s essential to understand the strategies of creditors in depth to avoid any drastic results.
If you work with a big bank, the default procedure can take a while or even a few years. For smaller lenders, your assets can be seized after only a couple of missed installments, depending on the moneylender. Despite your agreement, the repercussions can prove to be disastrous for both the business and the individual.
What Happens If Your Company Declares Bankruptcy?
If there is no possible way to repay your loans, you can file for bankruptcy. Under bankruptcy, your assets will be sold to the person who bids the highest. Your loan will be repaid through the money acquired through the auction. The expenses of the bankruptcy will also be taken from the money you receive from the auction.
In case of sole partnership and association, you might have the ability to petition for Chapter 7 bankruptcy to get rid of your obligation to business debts.
Consequences of a Loan Default
It is better to measure the consequences you might face in case your loan defaults before you do any paperwork and sign the final agreement. Only move ahead if you think you might be able to tackle the problems you might face in the future in case of business failure.
Drop in Credit Score
The main money-related consequence of defaulting on a business loan is a drop in your credit score. Your credit score might start dropping as soon as you miss your first installment. As the missed installments heap up, the score will drop considerably further, damaging your credit history.
Building up your business credit score can take a long time, so this can be a huge blow. The sooner you get yourself out of this financial mess, the better.
Increase in Interest Rates
As soon as your credit score starts dropping, you start incurring more debt through the increment of interest rates and your loans start to pile up. The vast majority overlooks that credit cards are a type of adjustable interest rate financing. It is important to note that if the everyday purchases for your business are made through a credit card, these purchases will turn out to be costlier. In case your personal credit is linked to your business credit, your personal loans might also be affected.
When you default, the lender will begin legal procedures to regain the cash lost in the loan. If your loan was guaranteed by a collateral, the lenders might seize this collateral. Lenders can also take this matter to the court and file a case against your business. The judge will decide the means through which your debt will be repaid. This may include the liquidation of your assets or enforcement of a lien on your funds. You might have to declare bankruptcy in case you are not able to repay the debts.
Difficulty Finding New Loans
Once your loan defaults, acquiring more loans in the future can be very difficult due to bad credit history. In case you are able to get out of your first loan default without declaring bankruptcy, you may need to utilize your own credit or insurance to keep the business running for a short time until the business can start making its own credit.
What Should You Do?
- Consider the flexibility of the creditors when it comes to repayment of loans since even if your business plans are well figured out, there is always a possibility of plans not working out and other unforeseen difficulties. It is better to have a thorough discussion with your creditor to know the consequences you might face if you happen to default on a business loan.
- Small business loan packages usually comprise of various documents, including a promissory note, a loan agreement, and some type of certification or security. Pay special attention to the word “fix” or “cure” in the default section of the promissory note. Fix loans allow a specific number of days – normally ten days – to handle the default after the bank has alarmed you.
- In case your business starts experiencing financial difficulties, you should draft out a financial plan as soon as possible so that you can avoid loan default. The plan should be made before you address your creditors, particularly if you’re ready to make a lower installment or need some other type of assistance. This will help you plead your case for substitute financing.
- If you have access to quick cash but can’t keep making standard installments, you might consider a loan settlement. You have to pay your lender a lump sum that can be anywhere between 20% and 70% less than the total amount if you agree to a loan settlement. The lender will close the record once the loan is settled.
- The sooner you contact your creditors after you miss an installment, the better. The lenders need to be paid even if it takes longer than the specified term in the loan agreement and might agree to establish a payment plan that will work for you both.
Tips You Should Know to Dodge Some Consequences of Loan Default
It is better to safeguard your personal assets before agreeing to a loan so that if your business defaults on a loan, your personal assets aren’t affected. Here are some tips that will come handy in this endeavor:
- Limit the Amount of Personal Assets That You Use for Your Business
When starting a new business, it’s difficult to get a customary business loan in light of the fact that your organization doesn’t have a history and reputation yet. Thus, numerous startups pull cash from their own personal savings and funds to establish their business. Utilizing your personal funds to support your business is practical but can be risky as well. Every business owner starts with a positive attitude and hope, but if your business fails in the long term, the personal funds you worked so hard to earn can be lost along with it.In case you do link your business funds with your personal funds, it’s better to leave at least 6 months’ worth of personal savings in a bank account to give yourself some breathing room if the business doesn’t develop as quickly as you expected.
- Know How Personal Guarantee Works
Even if you don’t link your personal assets to your business, it doesn’t mean that those assets aren’t in danger. While there are some unsecured business credit alternatives, most lenders request a personal guarantee from the business owners they give loans to. This enables moneylenders to repossess your property, vehicles, and other personal assets on the off chance that you default on a credit and utilize the returns to pay off the required installments. Use your negotiating skills in case you’re acquiring a significant amount of cash. If your business is running smoothly, a few moneylenders will limit the among of loan you need to personally guarantee. If negotiating does not work, consider partnering up for your business. Every individual who owns at least 20% of the business needs to provide a personal guarantee, so having partners divides the amount if the business defaults.
- Make Loan Payments on Time to Secure Your Personal Credit Score
Even if you get a business loan without a personal guarantee, there is always a chance that your personal credit might get affected. Most creditors inform credit agencies about the business loan which, in return, increases your overall debt level and can be disastrous for your personal credit history. Ask the creditor about their credit reporting strategy before signing the loan agreement. Most importantly, make sure you are paying all the loan installments on time. Most creditors do not contact credit agencies unless you are behind the installment schedule. If you are reported to the credit agency but have a smooth installment payment history, your credit history might be saved from any drastic impact.Before you sign any papers, make sure you are fully aware of how your assets are at stake in case your loan defaults.
As can be seen, getting out of loan default can be quite difficult at times. Therefore, it’s always better to be safe than sorry. Make sure you take loans only when you really need them and are sure you will be able to pay them back on time. Make sure you are keeping an eye on the cash flow so that you know if you will be able to make your loan payments on time.
In case you miss an installment, contact your lender as soon as you can to clarify your position and propose a reasonable business plan. If your strategy makes sense and your financial problems are likely to stop instead of being a constant issue, most lenders will agree to cooperate with you.
If your loan does default, make sure you contact an attorney or a professional who can give you the right guidance. Having an expert working closely with you will ensure that you take all the right steps.