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Small business financing is an important factor in the success of many independently owned companies. While there are risks associated with taking out any type of loan, business loans can provide the capital entrepreneurs need to fund a franchise or startup, pay for an expansion, purchase real estate and equipment, launch a social media marketing strategy, or simply cover operating expenses when business is slow. But taking out a loan can be an intimidating notion for risk-averse business owners. Many wonder what happens if they default on a loanâwhat will the consequences be if they fail?
In this article, weâll get to that. But first, some basic information about business loans.
The differences between an unsecured business loan and a secured loan
Most business loan options are either unsecured or secured, hereâs how to tell the difference:
Secured business loans
Secured loans require some type of collateral from the borrower. Collateral is a business or personal asset held by the lender to ensure the loan agreement is honored. The asset may be commercial real estate, jewelry, business equipment, vehicles, or any item of value. Securing a loan with collateral typically requires the borrower to hand over the title of the asset. With a secured loan, if the borrower defaults, ownership of the asset is transferred to the lender.
Secured business loans are riskier for the borrower than unsecured loans because the borrower stands to lose their asset if they are unable to pay, but they make it possible for borrowers with bad credit or no business credit history to get funding. For lenders, secured loans are less risky than other financing options because the collateral will act as compensation in the event of default. Since they carry less risk, secured loans offer lower interest rates than unsecured loans of the same value.
Unsecured business loans
Unsecured business loans do not require any type of collateral, instead, they are issued based on the creditworthiness of the borrower. The following factors are considered when an unsecured business loan or line of credit is in the underwriting process:
- Character â Examines size, location, time in business (new business or established), structure, staff size, reputation, and legal disputes.
- Capacity â Looks at the businessâs ability to pay bills on time by reviewing cash flow trends and payment histories.
- Capital – Evaluates the financial resources of the business by analyzing its financial statements and supporting documents, like bank statements.
- Conditions â External factors including market rates, legislative actions, Federal Government regulations, and currency rates.
One obvious advantage to an unsecured loan is that the borrower isnât required to relinquish ownership rights of an asset. Unsecured business loans also give entrepreneurs more flexible financing options that may include a line of credit, working capital loans, or term loans. The application process is expedited with unsecured funds because there is no need to have a formal estimate or appraisal on the collateral. Unsecured loans are also a great option for business owners that want more flexibility in what they use the funds for, as use is less likely to be specified in unsecured business loan terms.
What happens when you default on a business loan
Defaulting on a loan occurs when the borrower fails to make the required payments on the loan for a specified amount of time. Since every loan is unique, the repayment terms and conditions of default are clearly provided in the loan agreement. A borrower does not automatically enter the default period the first time they are late with a payment. The lender will notify the borrower if they are in default of their loan contract, but it typically follows at least 30 days of nonpayment or two consecutive missed monthly payments. If a lender does not receive a payment or response to the notification, the loan enters default, and the borrower is in danger of any of the following consequences:
Negative impact on credit report
Missed payments are reported to credit bureaus, where they remain on a credit report and lower the borrowerâs credit score. Unsecured business loans in default will be reported to the three main business credit bureaus: Dun & Bradstreet, Experian Business, and Equifax Small Business. The impact on the business credit score will result in decreased approval odds in the future, higher interest rates, and may even affect the businessâs customer or supplier relationships.
Defaulting on an unsecured business loan can also affect the personal credit score of the small business owner. It is common for unsecured financing options to require a personal guarantee. The guarantor is usually the business owner but can also be a friend, relative, investor, or other stakeholder in the company. The lender will pursue payment from the guarantor before beginning the collection process and the personal credit score of the guarantor will be lowered by the derogatory mark on their credit report.
If a small business owner defaults on an unsecured loan, they can be sent to collections and even sued. When an account is reported to a collection agency, it will appear on your credit report and result in countless calls, letters, and other attempts to contact the borrower. If there is still no payment, the lender or debt collector can begin the lawsuit process. Lawsuits are time-consuming and expensive and could leave the borrower paying additional fees and court costs. The lender may also be awarded authorization to seize assets and tax returns from the borrower, even though the loan was unsecured. Through the court action, the lender may succeed in taking possession of the borrowerâs property, like homes and bank accounts, or force them to liquidate certain business assets as debt settlement.
In addition to any legal expenses incurred by the borrower, defaulting on a loan will also result in late fees and nonpayment penalties. The allowed amount of late fees the lender can charge will be listed in the original loan documents or made available in the default letter to the borrower. Late fees may also accumulate interest, so as each day passes the fee increases.
On top of any court costs and late fees, defaulting on a loan will cost the small business owner in the future. The lender that issued the defaulted loan may have the authority to change the terms as a result of the nonpayment, which can increase future monthly payments. The loan going into default will also affect the future borrowing potential of the business and entrepreneur. Late payments or a loan that went into collections will appear on the borrowerâs credit history, bring down their creditworthiness, and result in higher interest rates and factor rates for new funding options.
How to avoid defaulting on an unsecured business loan
The consequences of defaulting on an unsecured loan can cost a small business a lot of time and money. Failing to pay on an unsecured debt is unavoidable in rare circumstances, like foreclosure and bankruptcy, but often there are steps a borrower can take to avoid defaulting.
Reach out to the lender
If you have already missed a scheduled loan payment or doubt your companyâs ability to pay the next one on time, contact the lender right away. Speaking with a representative from the financial institution that issued the loan is the best way to resolve difficulties paying and create a repayment plan. The lender may be able to offer a deferment or pause the repayment obligations. You may be able to negotiate new loan terms, like a longer repayment term, a lower fee schedule, or securing the loan with personal assets. Some options would lower the monthly payment and allow the business owner to increase their cash flow. Even if no action can be taken to help with payments, the lender will note that you made contact which may give you an extended period of time before they implement collections or legal actions.
Make smaller payments
Even if you canât afford to make a full payment on the loan, pay something. Making smaller, good-faith, payments will show the lender that you are making an effort and that you are interested in continuing the terms of the loan and will be a good candidate for a revised payment plan. The unsecured loan may still enter default, but the smaller payments will still contribute to decreasing the principal balance which will benefit the borrower in any outcome.
Review refinancing options
If the current loan terms are not working for the businessâs bottom line, refinancing the loan may be the answer. To refinance a loan, the borrower takes out a new loan to pay off the original debt. The intention behind refinancing a loan is to secure better repayment terms which lead to lower payments, an extended length of the loan, or a cash advance. Any refinancing option will carry less risk to the borrowerâs credit history than defaulting. Small business owners may be able to refinance with a secured loan by providing collateral or another unsecured loan option with a different lender.
Consult a professional
If youâre in danger of defaulting on a loan or already have missed a payment, there is professional help available after youâve reached out to your lender.
- Debt counselor â Debt counseling services can help your small business get back on track. Debt counselors work with creditors and lenders on behalf of the small business owner to consolidate or reduce debt and avoid business loan default.
- Bankruptcy attorney â If missing a loan payment was not an isolated incident and you are concerned that your business is entering a financial crisis, bankruptcy may be the next step. Bankruptcy is a legal process done by a bankruptcy attorney that can help overwhelmed individuals and businesses eliminate the total loan amount.
- Accountant â Work with an accounting service or CPA to improve the business finances. Missing loan payments may be a result of an emergency expense, a decrease in revenues, or ineffective budgeting. No matter the cause, sitting with a financial expert can help your business improve cash flow and figure out whatâs next for the business and your personal finances.
Can you get financing after defaulting on a business loan?
Entrepreneurs that have defaulted on a loan often believe they will not be eligible to be approved for business financing in the future. This is not true. It is possible to receive business funding or refinance previous debt, no matter the credit history. In fact, there are even lenders that specialize in working with all types of payment histories, including bankruptcy. Some great small business financing options for business owners with bad credit include:
- Invoice Financing â Invoice financing and invoice factoring are short-term financing options where the borrower receives funds in exchange for their unpaid invoices or accounts receivable balances.
- Equipment Financing â Equipment loans are a great option for businesses because the purchased equipment serves as collateral on the loan, making them accessible to borrowers with bad credit history.
- SBA Loans â The S. Small Business Administration guarantees a portion of loans issued through an approved lender, making them lower risk than unsecured bank loans.
- Merchant Cash Advance (MCA) â A merchant cash advance lets borrowers receive a lump sum payment upfront in return for a portion of the businessâs future sales from credit cards.
Defaulting on an unsecured business loan can cost the company a lot of time and money. Legal actions against the borrower and a negative impact on the business credit history are consequences that stay with the business long after the missed payments. To avoid defaulting on a loan:
- Contact the lender
- Make partial payments
- Consider refinancing options
- Work with a professional
If you are having trouble making monthly payments on a loan, the most important tip is not to panic. Consider the suggestions in this article or work with a lender to review refinancing options. Even with multiple accounts in collections, this property management business owner was able to get approved for an unsecured line of credit through Biz2Credit.