What It Means to Default on a Business Loan and What to Do Next

What happens when you default on a business loan

Defaulting on a business loan means you’ve failed to make payments or breached other loan agreement terms. Default processes vary by loan agreements and state, The ones outlined below are standard in New York. However, many traditional and alternative lenders not based in New York still operate under New York law or use it as a standard in their loan agreements, regardless of where a business is located. 

Experts say business owners who know they’re headed toward a loan default should contact their lender as soon as possible. Depending on the type of lender, it may reduce your interest rates, offer interest-only payment options or restructure your loan terms until your business is back on track.

However, if you don’t reach out beforehand, here’s how the loan default process typically works:

1. Loan payments are missed and your loan enters delinquency: Missed payments typically trigger a loan default. When you miss a payment, your loan enters delinquency, which is the first step toward defaulting. With some smaller loan companies and alternative lenders, your business assets may be frozen after a few missed payments. If you work with a larger bank, the default process can take several months or a couple of years. Simon Goldenberg, a New York-based attorney specializing in debt relief for small businesses and individuals, explained that six months of missed payments is a common benchmark for triggering a default.
2. The lender will reach out: Once you’ve missed a few payments and your loan is delinquent, your lender will likely contact you to find out what’s going on with your business. This is a crucial bargaining period that can mitigate immediate ramifications. You and the lender may even be able to set up a reasonable plan for you to pay back the loan. “The creditor will reach out to the debtor and say, ‘Hey, look, you’ve missed a payment. Let’s get that cleared up. What’s going on in your life?'” Goldenberg said.
3. The lender may demand an accelerated balance: Once a loan is in default, many lenders will trigger an “acceleration clause,” which requires you to pay the entire remaining loan balance immediately. “At the time of default, generally, the full balance will become accelerated,” Goldenberg explained. An accelerated balance means that you’ll be on the hook for the total loan amount instead of owing your missed monthly payments and any accrued interest. From here, the lender will tack on applicable fees outlined in your agreement, such as collection fees, attorneys’ fees and other predefined charges.
4. Legal action and collection efforts may follow. The next steps can vary widely if you and your lender fail to reach a resolution — particularly if your loan has a personal guarantee (more on personal guarantees below). The lender may take legal action or work with collection agencies to recover the debt. Goldenberg cited two common routes in these situations:
   • The lender will seize and liquidate your business or personal assets to cover the loss. Wage garnishments, liens on business property or asset seizures are possible. 
   • The lender will cut its losses and settle with you for a defined amount.
5. Your credit score is impacted: Loan defaults are reported to credit bureaus, so your personal and business credit scores will be affected significantly. You may have trouble securing financing in the future. This can make it difficult to secure future financing and if you do obtain credit again, you’ll likely face higher interest rates.

Defaulting on a business loan can have devastating consequences for your business and personal life. “Small business owners need to understand that their business financial decisions can have personal consequences,” cautioned Jay DesMarteau, chief commercial banking officer at Northwest Bank.

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How to avoid defaulting on a business loan

The best thing you can do as a borrower is contact your lender when you start missing payments. If you’re transparent with them, most lenders will work with you in some way. If you’re worried you may default on a loan, here are some steps you can take.

Look into credit counseling.

The National Foundation for Credit Counseling (NFCC) provides small business owners and individuals with free legal counseling and resources. It can be a great place to start if you’re looking for more guidance on a loan dispute.

Consider the type of lender you’re working with.

Rodney Ramcharan, a finance and business economics professor at the University of Southern California Marshall School of Business, emphasized that your lender will dictate much of your default process. 

“If you’re borrowing from a bank that’s strictly arm’s-length, so it only uses data to score and evaluate these loans, then your ability to get some kind of dispensation from the bank could be much more constrained than if you are lending from a relationship-based lender who … might be more inclined to use soft information to not foreclose upon this loan,” Ramcharan explained.

Partnering with traditional or local banks gives you a greater chance of working through issues as they arise. Goldenberg said arm’s-length lenders, such as MCAs, have different funding practices and may be in a position where their primary concern is just getting their money back.

“When you have a bank, they sort of understand this business on a much larger scale, [knowing that] there’s always going to be some underperforming accounts,” Goldenberg noted. “With MCAs, you might have an individual person that funded that loan or maybe a small group of private investors that put down money toward funding a particular company … they’re not a large corporation.”

That means the stakes for working with arm’s-length lenders are different from traditional or local banks and it’s critical to understand this distinction as a borrower.

Try to compromise with your lender.

Some lenders, including those for SBA loans, may work with you on an offer in compromise, which allows you to settle your loan debt for less than the full amount owed. An offer in compromise is an option for borrowers who cannot repay the entire amount or if doing so would create undue financial hardship. Similarly, the IRS has an offer in compromise option for settling tax debt for less than the total liability.

If you pursue this option for either loan or tax debt, it may be helpful to contact a business attorney or tax professional who specializes in debt settlement to help you navigate the process.

Consider restructuring your loan.

Consider options like loan modification or business loan refinancing, which involves renegotiating the terms of your loan agreement with your lender. Assess your financial situation, understand the loan you want to restructure and determine a realistic repayment plan. Clearly explain your financial difficulties and propose potential solutions like extending the repayment period or lowering the interest rate. Be prepared to negotiate and be sure to get any agreements in writing. 

Work with an attorney and financial professionals. 

Legal and financial professionals can help you avoid defaulting on a loan — or help guide you through the process, if necessary. For example, a business attorney can help ensure you understand a loan agreement’s intricacies, negotiate favorable terms in case of financial hardship and comply with relevant laws. A financial professional, including a certified public accountant (CPA), can help you manage your finances and stay on track. 

Legal and financial professional guidance can help you take proactive steps to safeguard your business, minimize default risks and increase the chances of a successful loan journey.

Defaults can be managed if you work with your lender 

The best strategy for maintaining a healthy, financially stable business is to maintain good cash flow and follow meticulous accounting practices, using the best accounting software and financial guidance.

DesMarteau stressed that keeping business and personal finances mutually exclusive is an essential first step. “Muddling finances can cause SBOs [small business owners] to miss any warning signs that their business finances aren’t on track or make it easier to ‘borrow’ money from the business to pay personal needs, which can cause them to slip up on a payment or overdraft accounts,” DesMarteau explained.

Sometimes, default is unavoidable. However, it is crucial to work with your lender and use any available resources. “Most lenders would appreciate a forthcoming debtor and might actually reciprocate with courtesy to a debtor who is acting genuinely, sincerely and proactively to try to come to reasonable terms,” Goldenberg said.

Mike Berner and Jamie Johnson contributed to this article. Source interviews were conducted for a previous version of this article.