For most small business owners, when they take out a business loan, they think about how the loan is going to take their business to the next level. The last thing on their mind is what will happen if they can’t pay it back and default on the loan.
Defaulting on a loan can have serious consequences, so it’s important to understand what you’re putting on the line when you get a personal or small business loan.
What Does It Mean to Default on a Loan?
When you get a personal or business loan, you agree to make periodic payments according to a schedule spelled out in your loan agreement. When you fail to make those payments as agreed, you breach the contract. After a certain period of nonpayment (or partial payment) the loan will be considered in default.
Consequences Of Loan Default
Loan default can have a number of consequences depending on factors that include whether:
- The loan is secured with collateral or unsecured
- The loan is a consumer or business loan
- The terms of the contract
- State and federal laws
Attorney Jeffrey Hyslip, founding member of Hyslip Legal, LLC, explains some of the consequences of defaulting on a loan:
“What the creditor can do when a consumer misses a payment is largely dependent upon the terms the consumer signed when agreeing to borrow the money. In law, these common terms for not paying back money or for breaching any contract are called “remedies”.
Nearly every contract contains a “default” provision which specifically spells out the remedies available to creditors in the event of breach. Common remedies include acceleration, increased default APR, set-off and cross-collateralization. It is common for contracts involving borrowing money to have an acceleration clause. If so, if a consumer defaults on a loan the entire balance can become due, not just the payment that was missed.”
Cross collateralization is another possible consequence. Hyslip explains it like this:
Let’s say John is unable to make his minimum monthly payment on his credit card he has with Hyslip Bank, LLC. As soon as he misses his payment, he is deemed to be in breach of his credit card agreement. Because of “cross collateralization” clauses (often buried in the default clause of a contract), if John defaults in one loan to Hyslip Bank, LLC, the bank has the option of deeming ALL loans (credit cards, cars, mortgages) that John has with the bank in default too. Moreover, if John also had a checking account with Hyslip Bank, LLC – Hyslip Bank, LLC could go into John’s checking account and – without notice – remove money from John’s checking account to make the bank “whole”. This is called ‘set off’.”
Falling behind on debt payments can set off a cascade of problems. Many of these consequences, including acceleration clauses and default interest rate, apply to many small business loans as well. Miss a payment on a business credit card and the issuer will often raise the interest rate on the existing balance. (They are not able to do that as quickly with consumer credit cards due to the federal Credit Card Act.)
It’s always a good idea to talk with a legal professional if you are having trouble paying your debts. A bankruptcy attorney can explain what lenders can and cannot do to collect from you. “When I am speaking to consumers that are either unable to pay their bills or believe they might be unable to pay their bills in the future, it is important for them to meet with an experienced consumer finance attorney as there are meaningful ways consumers can protect themselves from disaster or unintended consequences prior to defaulting on loans,” Hyslip says.
Here are important considerations to keep in mind:
Let’s start with personal guarantee. Many small business owners sign a personal guarantee when they take out a business loan. (A personal loan by definition is guaranteed personally.)
It’s worth noting that if you operate your business as a sole proprietor, there is no legal distinction between you and your business. That generally means you agree to repay the loan out of your personal income and assets, even if it’s a business loan.
But if you operate your business through a legal business entity such as a LLC, S-Corp or C-Corp, you are generally not personally responsible for the loan unless you personally guarantee it. That limited liability is one of the benefits of forming a business entity.
Read here about why lenders and vendors want personal guarantees.
Many small business lenders require personal guarantees. Certain types of financing, like merchant cash advances, instead use a performance guarantee. You may not personally have to pay back the financing if your business truly goes under, but otherwise the business is responsible for repayment of the funds advanced.
A secured loan involves collateral. In the case of a personal loan, secured loans are usually:
- Auto loans. The vehicle serves as collateral for the car loan and can be repossessed.
- Title loans. Here a vehicle is also used as collateral for a loan, though funds aren’t used to purchase the vehicle.
- Mortgage loan. The home or property serves as collateral and may be foreclosed upon.
- Secured credit card. A deposit is made in order to qualify for the credit card and can be forfeited in the event of default.
With business loans, you pledge something the business owns that’s of value—equipment, inventory, real estate or even future receivables—as collateral for the loan. A blanket lien on your business assets means the lenders can go after your business assets if the loan becomes delinquent.
Typically, business financing companies will place a UCC filing against the business, and that will appear on your business credit report.
Debt Collection Process
If you fall behind on payments on a personal or business debt, you’ll probably first hear from the lender. Some lenders will offer payment options to help bring the defaulted loan current.
For example, federal student loan servicers may provide information about payment options including forbearance or deferment where you can stop making payments for a period of time.
Otherwise, your loan will probably enter into the collection process. The lender may have an internal collection department or may turn the debt over to a third-party collection agency after a certain number of missed payments.
In the meantime, late payments and interest will often be added to the debt and late payments may be reported to personal and/or business credit bureaus, which can make it harder to refinance the debt.
At some point, the lender or the collection agency may sue the individual or the business to collect. If it’s a small amount, they will go through the small claims court. Otherwise, they go through the regular court system.
If there is collateral involved, the lender may seize that collateral or initiate legal proceedings to do so. Again, the process will depend on a number of different factors but it is important to understand that you could lose your home or car if you’ve pledged either as collateral for a business or personal loan.
If the lender’s lawsuit is successful it will get a judgment against the borrower or business and may be able to collect in a variety of ways, including seizing certain assets like bank accounts or with wage garnishment.
If you have a bank account with the same financial institution that gave you a loan, it’s possible that money could be seized to pay the debt.
Business Loan Default vs Personal Loan Default
When it comes to the consequences of defaulting, there are important distinctions between business loans and consumer loans. That’s because different laws govern how each type of loan may be collected.
Those differences may impact:
- How they can attempt to collect (debt collection)
- What assets they can try to seize for payment
- Whether and how the debt may affect your credit
The federal Fair Debt Collection Practices Act (FDCPA) places significant restrictions on how third party debt collectors can contact consumers. But that law doesn’t apply to small business debt collection.
If you default on a business debt, you may face lots of phone calls, and debt collectors may even reach out to colleagues, friends or family unless it’s illegal to do so under state law. (That doesn’t mean a debt collection agency can do anything to collect a business debt. The FTC sued two finance companies that allegedly deceived small business owners and used threats of violence when collecting debts.)
One reason business owners form business entities is for asset protection benefits. However, if the business owner signed a personal guarantee or if they took actions that allow creditors to “pierce the corporate veil,” they may be able to try to collect from personal assets.
Not everything the business owner owns personally is fair game. Retirement accounts, some home equity and other assets may be safe from creditors or collectors but that varies by state, so be sure to consult a bankruptcy attorney if you believe your personal assets are at risk.
On the consumer side, creditors may be able to use wage garnishment or even seize bank accounts or tax refunds, but usually only after they have taken the borrower to court and obtained a judgment.
Typically business loans may be reported to business credit bureaus, and personal loans to consumer credit reporting agencies.
If you sign a personal guarantee for a business loan, you agree to be personally responsible for loan payments if your business cannot pay them. (The same goes for any co-signers.) And that means the lender may report a loan default—or even missed monthly payments—to consumer credit reporting agencies.
In other words, your business debt problems may affect your personal credit and lower your credit scores. That’s not always the case, but it is a possibility to keep in mind.
Small business debts may be reported to business credit bureaus. Some lenders that report to business credit only report negative information. In other words, the account may not appear on your business credit reports unless you default, so don’t assume that because the loan does not appear on your business credit report that it can’t affect your business credit scores. Even if the lender doesn’t report, a collection account or court judgment could affect your credit.
That raises one more important difference between consumer and business credit reporting. Consumer credit reports generally no longer include tax liens or judgments, but business credit reports often do.
What if You’ve Already Defaulted on a Loan?
If you’ve defaulted on a loan, the biggest mistake you can make is to assume that you can ignore the debt, either because you can’t afford it or because you haven’t heard from the lender in a while.
Debts are covered by state and federal statutes of limitations which give lenders a certain amount of time to try to collect. The statute of limitations may be as short as a couple of years or as long as ten years or more. Sometimes lenders or collectors will pause collection on a debt and monitor the financial situation of the borrower. They may later decide to try to collect or even file a lawsuit to extend the statute of limitations.
Again that’s why it is important to get legal advice so you can understand your options.
Sometimes filing for bankruptcy may be the best (or only) option for putting your debts behind you.
The following debt relief resources may be helpful if you are struggling with consumer and/or business debts:
- The National Foundation for Credit Counseling (NFCC) can put you in touch with a consumer credit counselor. They help consumers and the self employed.
- A bankruptcy attorney can help you understand what’s at risk if you can’t pay your debts, and can help you decide whether it makes sense to file for business bankruptcy and/or consumer bankruptcy.
- The Consumer Recovery Network provides helpful information about debt negotiation and debt settlement, both for consumers and small business owners.
Often by the time you default, a loan to refinance the debt may not be an option. Your credit reports may have been affected, and some lenders require you to disclose any defaulted loans when you apply. But if your credit reports have not been affected, and you or your business now has the means to make payments, you may want to look into debt consolidation.
How To Prevent Future Loan Defaults
Running a business means a lot of uncertainty and there’s no guarantee that what works today will work tomorrow.
Losing a key client or even a key supplier can throw a business into a cash flow crunch. While small business loans and financing can help bridge that gap, if the business doesn’t land new clients or solve supply chain issues, it may not be able to pay its debts.
Options to consider when you’re considering how to prevent future loan defaults:
- Keep your budget and your bookkeeping up to date. Accounting software can help you produce financial reports that help you understand the financial health of your business so you don’t miss growing problems.
- Use a business bank account. Don’t commingle business and personal finances. Not only is it legally risky if you operate as an LLC or corporation, it also makes it very difficult to clearly monitor what’s happening with your business.
- Get help. SBA Resource partners such as SCORE or Small Business Development Centers can’t give you legal advice, but they may be able to help you identify ways to turn around your business. Services are mostly free, though a few offerings may carry a small fee.
- Nav can help with tools to help you keep a pulse on your business financial health. Get started now.
You’ll also want to think carefully in the future about providing a personal guarantee or personal assets such as home equity as collateral. It’s definitely a trade-off.
Unsecured loans may carry higher interest rates. Some of the loans with the best interest rates (like bank loans and SBA-guaranteed loans) require collateral if it’s available.
Ultimately you’ll need to make the debt decision for your business and personal finances. Keeping close tabs on your business financial health may help you make better decisions before a crisis arises.
Frequently Asked Questions About Loan Default
What Is the Difference Between a Loan Default and a Loan Delinquency?
When you miss a payment on a loan, you are often considered delinquent on the loan. (Some loans offer a grace period before late fees may be charged, but that doesn’t necessarily mean the loan is not delinquent.)
Past due payments may immediately trigger default, but not always. It’s important to review your loan terms because your loan may be considered in default after one missed payment.
How Will Defaulting on a Business Loan Affect My Personal Credit?
Defaulting on a business loan may or may not affect your personal credit. It depends on whether there is a personal guarantee and whether the lender chooses to report to personal credit. Some will not. The SBA, for example, requires personal guarantees for larger EIDL loans, but does not have a mechanism for reporting to consumer credit.
This article was originally written on November 6, 2014 and updated on August 22, 2023.