Let’s learn what happens when your business defaults on a loan, including the possible impact on your business and personal finances as well as about your options for avoiding default.
When Is a Business Loan in Default?
Your business loan agreement will describe the terms for when your loan can be declared in default, including if you fail to make monthly payments when they are due. The agreement usually allows a grace period of a specific number of days. Other common reasons for defaulting on a business loan are if the borrower:
Admits they are unable to pay Files for bankruptcy Makes an assignment for the benefit of creditors Consents to the appointment of a trustee or receiver for business property Is declared bankrupt or insolvent under federal or state law Has received a court order appointing a receiver or trustee
Default vs. Delinquency
A borrower may be delinquent on a loan before default is declared. You are delinquent on a business loan when you miss a payment and you may have to pay a late fee, depending on the terms of your loan document. If you are delinquent for several months, the lender may declare your loan to be in default.
How Defaulting on a Loan Impacts Your Business
When a lender determines that a loan is in default, one of several things can happen, depending on the situation and the terms of your loan agreement.
Seizing Assets in a Default
Most commercial loans are secured by collateral, and the lender may liquidate, sell, or dispose of the collateral you used to secure the loan, such as business equipment or vehicles. It will use the proceeds to pay off as much of the debt as possible. In the case of a Small Business Administration (SBA) loan, the SBA will pay off the federally guaranteed portion of the remaining loan balance, typically after the bank’s liquidation process.
Business Loan Acceleration
Lenders may also accelerate the loan if the borrower is in default. In this case, the borrower must pay off the entire amount of the loan immediately. The loan document will describe the details of acceleration, including how interest is charged. Even if the document has a default clause, the lender may choose not to invoke it, or you may be able to repair the damage by paying a specific amount as agreed to by both parties.
Loan Default on SBA Loans
Many small businesses receive loans backed by the SBA. The SBA doesn’t directly give loans, but it gives guarantees to the lender to repay up to 85% of an eligible bank loan with a maximum of $3,750,000. SBA-guaranteed loans have specific triggers for default on a loan that may be different from a non-SBA loan. For example, if you sell collateral to make your loan payment, you may be in default. If you have a Paycheck Protection Loan or certain other types of SBA-guaranteed loans, you may be able to apply for loan forgiveness if you meet certain requirements.
Business Loan Defaults and Your Personal Finances
Defaulting on a business loan can affect your personal financial situation and your personal credit, depending on your business type. Some business types, including limited liability companies (LLCs) and some forms of limited liability partnerships, give the owners some liability protection against the debts of the business. If your business is a corporation, the business and your personal financial situation are separate, so a loan default means you will not be held personally responsible for the debt. Sole proprietor businesses and general partnerships are not separate from their owners, so the owner has unlimited liability (personal responsibility) for the loan.
Business Loan Defaults and Personal Guarantees
Since new small businesses often don’t have assets to secure a loan, lenders typically require the owner to sign a personal guarantee for the business loan. In this case, the owner may have to pledge specific personal assets as collateral. Personal guarantees for business loans override the liability protection of LLCs, limited liability partnerships, and other types of limited partnerships because the individual has explicitly agreed to pay off the debt. When you sign a personal guarantee, your personal finances won’t be protected from being impacted by the business debts, no matter what type of business you have.
Business Loan Defaults and Bankruptcy
If a business doesn’t have assets to pay off the loan, a default may force it into bankruptcy. If the business is a sole proprietorship or partnership, this may mean Chapter 13 bankruptcy, which allows businesses to keep their assets while they restructure and renegotiate their debt. Other businesses may file either Chapter 7 liquidation, which results in all assets being sold to pay creditors and closing the business, or Chapter 11 reorganization, which is a more complex bankruptcy that allows for reorganization.
How To Avoid Defaulting on Your Business Loan
You may be able to renegotiate your business loan if you can show that your situation is temporary, due to cash flow issues, for example, or that you have some assurance of orders or new customers in the future. Other possibilities for situations when a default has lowered your business credit score:
Some peer-to-peer lenders make loans to companies with lower credit scores An SBA micro-loan for working capital or inventory purchase (but not to refinance existing debt)
If you have an SBA loan, you may be able to get an offer in compromise to settle with the lender for less than the full amount due. You can make this offer after all assets have been liquidated and there is still an outstanding amount owed. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
