What Happens if You Can’t Repay Your SBA Loan?

How SBA loan default and forgiveness work

If you are a small business owner in danger of defaulting on your SBA loan, here’s everything you should know:

1. Your lender will be your first point of contact.

Even though your loan is called an SBA loan, your lender makes day-to-day servicing decisions — not the SBA. If you’re struggling to make payments, your first step should be to contact your bank.

Mark Valentino, head of business banking at Citizens Bank, noted that lenders will try to help businesses avoid loan default. “If you find yourself unable to meet payments, start by getting in touch with your lender,” Valentino advised. “They are most often able and willing to work together and come to an agreement, such as determining repayment terms that align with the status of your finances.”

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Typically, a lender can offer two types of assistance: Loan modification or deferment:

• Loan modification: A modification most frequently comes in the form of a term extension, which pushes back the loan’s maturity date. For example, if your loan is modified to mature in 10 years instead of five, your monthly payments will be significantly reduced. 
• Deferment: A loan deferment is a short-term solution. Deferments are usually available for three to six months or, in some cases, up to 12 months. Deferments are intended for temporary financial challenges, such as a broken water pipe that shuts down operations for a month or a large order that depletes working capital.

Keep the following advice in mind when speaking to your lender: 

• Be polite: When speaking with your bank about a loan modification or deferment, stay calm, professional and responsive. While there may be times you’ll need to push back on the lender, avoid an aggressive approach unless necessary. Be courteous, return calls promptly and provide the required information on time. Making your lender’s life easier can only help your case.
• Communicate transparently: Sally Graham, a former public affairs specialist with the SBA, stresses that communication is key for borrowers anticipating repayment issues on an SBA loan. “If a borrower is anticipating or experiencing cash flow issues, emergencies or declared disasters, communication is key,” Graham said. “They should meet with a resource partner and contact their lender. SBA lenders make good faith efforts to bring borrowers back into good standing (or ‘compliance’) in situations where default might be temporary, a mistake or fixable.” 

2. The SBA will consider settlements.

Modifications and deferments are great for short-term financial struggles, but when a business is bleeding cash with no end in sight, a deferment is akin to a Band-Aid on a broken leg — it’s not enough. In many cases, the only way to solve the problem is to shut down the business. That’s never an easy decision, but it can often be the right one.

Ideally, once your business closes, that would be the end of it. Unfortunately, it’s not. The vast majority of SBA loans require personal guarantees so, even if your business is closed, you’re still responsible for repaying the debt.

While the bad news is that you could potentially be on the hook for a significant sum of cash, the good news is that the government understands it can’t get blood from a stone. That’s why the SBA is willing to consider settlements, a process known as “offer in compromise” (OIC).

It’s important to note that an OIC is not guaranteed and not everyone is eligible. Various factors determine whether the SBA will consider some level of forgiveness but, in short, the borrower must prove financial hardship and an inability to repay the debt over a reasonable period.

3. Settlements are based on a few broad concepts.

Settlements aren’t always straightforward. Consider the following:

• A settlement should align with what the SBA could recover: A settlement should bear a reasonable relationship to the amount recoverable through enforced collection. Essentially, the SBA compares your offer to what it believes it could recover if it pursued legal action against you. Can it levy your bank account or garnish your wages? If so, keep that in mind when devising your offer. Having limited garnishable assets may help your case but it doesn’t mean you’re off the hook.
• You may need to access protected funds: However, don’t lean too much on the point above. You can’t ignore your lender just because your assets are in a 401(k) retirement account. To qualify for a settlement, you must demonstrate financial hardship and an inability to pay the full amount. This means that even though the SBA can’t force you to withdraw from protected accounts, you may need to do so voluntarily to reach a settlement.
• Your settlement amount isn’t arbitrary: The amount you settle for will be tied directly to your personal financial situation — not an arbitrary percentage. The SBA and your lender will require full financial disclosure, including a personal financial statement (SBA Form 770), tax returns and bank statements.
• The U.S. Department of the Treasury may step in if no settlement is reached: If you fail to work out a deal with your lender or the SBA, the Department of the Treasury will base its settlements on an arbitrary percentage. Additionally, settlements are based on what you can afford — not what’s convenient for you — so don’t expect an easy or inexpensive resolution. 

4. Settlements come with strings attached.

While settling your debt can be a financial and emotional relief, it’s not all rainbows and unicorns. Be aware of these stipulations:

• SBA debt forgiveness may be taxable: If a lender forgives part of your debt, you may receive a 1099 form for that amount. The SBA may also report settlements to the credit bureaus. However, you may be able to dispute the report if the debt was not consumer-related.
• You’ll land on a government blocklist: The government maintains a Credit Alert Verification Reporting System, which tracks borrowers who have defaulted on federal obligations.

What happens if you default on an SBA loan?

If you don’t respond to your demand letter, the SBA will send your debt to the Department of the Treasury for collection under the Treasury Offset Program.

Once your debt reaches the Department of the Treasury, it has several ways to collect:

• Wage garnishment
• Social Security benefits garnishment (or other retirement benefits)
• Withholding federal income tax refunds
• Offsetting your bank accounts

Because your loan is backed by the federal government, there’s no statute of limitations on how long it can remain in collections. Additionally, the government does not need a court judgment to initiate garnishment. You might be able to settle with the Department of the Treasury, but it’s unlikely — and, if you do, it will be for much more than what the SBA would have accepted.

Joe Camberato, CEO of National Business Capital, reiterated the importance of contacting your lender immediately if you suspect you may default. “In these unfortunate situations, you really want to be proactive with communicating with your lender,” Camberato said. “If you elect to do nothing and not respond to your lender, [it] forces the lender to take quick action.”

Camberato also suggests seeking legal advice to understand your options. “If you’re in the situation, I strongly suggest speaking with an attorney who is well-versed in understanding SBA loans, along with bankruptcy protection,” Camberato noted.

Because SBA loans typically require a personal guarantee, Camberato warns that defaulting could have serious personal consequences.

“SBA loans usually come with a personal guarantee, which means if you default, the lender can come after you personally to recover the money,” Camberato said. “On top of that, they might have a second lien on your home if you own one, so your house could also be at risk. Defaulting on any loan isn’t something you want to take lightly.”

How to avoid defaulting on your SBA loan 

Defaulting on your SBA loan should be a last resort — it often means your business is in serious financial trouble. Here are some ways to avoid default:

• Understand your obligations before borrowing: Graham pointed out that the SBA offers counseling services to borrowers at many locations across the country. The advice you receive could impact your loan’s success. “SBA’s first priority is to ensure that small business owners are educated in how to access capital and how to use it responsibly,” Graham explained. “Small business owners can get free or low-cost counseling through SBA’s district offices and resource partner network across the nation.”
• Obtain legal advice before reaching the default point: Valentino encourages even the smallest businesses to work with financial and legal professionals to prevent loan default. “Even though financial and legal professionals charge fees, they will put checks and balances in place that safeguard your financial future and that of all of your business’ stakeholders,” Valentino said.

However, if it’s too late for these efforts and you are facing default, consider these options:

• Increase cash flow: As soon as you start struggling to make your loan payments, identify ways to improve cash flow and reduce business expenses. For example, try renegotiating with vendors and reducing the shifts hourly employees work. You can also lower the salary you draw from your business to raise cash. 
• Sell unused assets: Consider selling off business assets like equipment, underutilized vehicles or real estate to help pay your debt.
• Consolidate loans: If applicable, see about consolidating existing business loans to get better terms and free up cash.
• Sell all or part of the business: A sad but realistic option may be selling the business and using the cash to pay off your debt. While a struggling business may not get top dollar, it could be valuable to a competitor or a company looking to enter your market. Alternatively, you might be able to sell part of your business, such as:
  • A product line you haven’t been able to maximize
  • Some of your intellectual property
  • Access to your customer list 

Consider alternative debt

If you’re confident you’ll generate sufficient revenue within the year, consider a bridge loan, credit card receivables financing or invoice factoring. You might also want to explore refinancing your loan with an alternative lender that offers more flexible repayment terms.

No one takes out an SBA loan expecting their business to fail — but it happens every day. Is it an easy situation to navigate? Not at all. However, if your business begins to struggle and you’re considering shutting down, settling your SBA loan could be an option.

Matt Sexton contributed to this article.