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Businesses can encounter challenges that can put pressure on cash flow. Depending on the size and duration of the challenge, a business might have trouble paying back its debt obligations and can slip into default. While a business loan default is not a situation you want to be in, there are ways to prevent them from happening and ways to recover from them. The core of this article will explore ways to prevent a business loan default.
When are you in default?
The first step to preventing a business loan default is understanding exactly when you are in default. There is no universal rule that applies to all loans to know when you are going to default. However, broadly speaking, if you have missed payments for 3-6 months most lenders will consider your loan in delinquency. When your specific business loan is in default depends on your lender and loan terms. Some lenders offer a grace period when making loan payments so you might not be in default if you are a single day late on a payment. But with other loan agreement terms, you might be.
Ideally, this is information you know before closing on your loan so you can plan accordingly. If you have an active loan for your business, and you don’t know the details around when you are in default, contact your lender as soon as possible to understand this.
If you are in the process of obtaining a loan for your business, ask your lender about the payback terms, if there is a grace period, fees associated with late payments, and wrap your arms around when you are considered to be in default.
If you are concerned that your business will default on its loan, contact your lender before it happens. You are not the first business to default on your loan and certainly will not be the last. Once you contact your lender and let them know about your situation, you will likely enter a bargaining period that can mitigate immediate ramifications and avoid long-term damage to your business.
Your lender doesn’t want you to go into default because it triggers a series of steps they will take to reclaim their money. We will dive into these deeper later in the article, but if your lender needs to take legal action to collect their money, which might include seizing business or personal assets, it costs them time, effort, and money so they might be willing to work with you depending on your situation.
They may let you refinance, make interest-only payments for a time, or some other special repayment arrangement. If you’re facing this situation, it will help your chances if you can present information on your business finances. For example, maybe you’re going to default, but you just landed a big contract that will bring in additional cash flow 60 days from now. Your lender will likely consider this information when deciding on how to proceed with your account.
Reach out to a debt settlement attorney and/or a bankruptcy attorney that specializes in business loan defaults to help you plot a course to prevent long-term damage to your business. They can also help guide you on how to recover from a business loan default.
Ways to avoid a default
Below is a broad list of tactics to avoid a business loan default. Consider how each might apply to your situation:
- Continuously review expenses: As a business operator, you need to be diligent about your cash flow and where you are spending your money. Understand your monthly fixed and variable costs and review your spending habits frequently. This motion will allow you to create a contingency plan to outline what expenses can be cut should cash flow gets tight. If you decide to contact your lender before default (as we discussed above), your business expenses will be valuable information for the lender as they decide on a course of action for your account.
- Tap into the emergency fund: Having an emergency fund in place can help your business avoid default during short-term challenges. For example, if your business is generally healthy, but a customer payment is late, you can tap into your emergency fund to avoid default and replenish it when the customer payment goes through.
- Use a business credit card: Using a business credit card to avoid default might sound unusual, but depending on your situation it might help you navigate a short-term challenge. If your business credit card allows you to take a cash advance, you might determine that the high fees associated with the cash advance outweigh the negative impacts of going into default on your loan because you will be able to pay back the debt put on the credit card in full and on time. In this scenario, you are essentially transferring a portion of your debt from your loan balance sheet to your business credit card. Knowing the interest rate and late fees associated with your business credit card will play an important factor to determine if this short-term fix is right for you. Your business credit card likely has a much higher interest rate than your loan, so this option likely isn’t a long-term solution to help you pay down your business loan.
- Use business line of credit: Unlike many small business loans, which typically have rules around what the money can be used for, a business line of credit is more flexible and is a way to better manage cash flow. Similar to using a business credit card, by using a small business line of credit to prevent a business loan default, you are simply transferring a portion of your loan debt to the line of credit. Using a business line of credit will have more favorable interest rates than a business credit card and will give you a longer period to pay back the debt. However, you need to determine if having another debt obligation on your balance sheet outweighs the negative impacts of going into default on your current business loan. For additional information on a business credit card and a business line of credit, review our article on Business Credit Card vs. Line of Credit: What’s the Difference?
- Taking out another loan/consolidating debt: With some loans, it is possible to use the proceeds to pay off the debt of another loan. While this can be a short-term fix, be cautious of the “loan-balance-transfer dance”, as it is not an ideal way to operate a business. The proceeds of some loans do not allow for this either. For example, proceeds from an SBA microloan cannot be used to pay existing debts, and proceeds from an SBA 504 loan cannot be used for consolidating, repaying, or refinancing debt. However, refinancing existing business debt, under certain conditions is allowed with the proceeds from an SBA 7(a) loan. For more information on if you meet those conditions for an SBA 7(a) loan, read about the terms, conditions, and eligibility on the US Small Business Administration website.
Each of these bullet points is a way to prevent a business loan default. But remember, you will need to determine which approach is best for your business as each situation is different.
What happens if you default?
Defaulting on a business loan is not an ideal situation. When you default, a sequence of events is set in motion that can wind up with you closing your business for good. The consequences are broad depending on your specific situation and can have a lasting negative impact on your business and in some cases your personal finances. Depending on your loan and lender, these things can happen when you default on a business loan:
- Loan acceleration: An accelerated loan balance means that you are now responsible for the full loan amount. Instead of just owing missed monthly payments and any accrued interest, the entire loan balance is due. The lender will also add on any fees like collections fees, attorneys’ fees, or various other charges.
- Collections: Your lender might begin legal action to collect their money and use a collection agency. Depending on how your loan was structured, this can include seizing business or personal assets. Assets used to secure a business loan now in default (i.e., a secured loan or a loan using a personal guarantee) may be seized and sold by your lender. Having assets seized might mean your business can no longer operate. For example, a farming business that used critical farm equipment as collateral. Personal assets such as your home or personal bank accounts may also be seized if they were used to secure your loan. While unsecured loans exist, most lenders try to secure your loan with collateral to give them a vehicle to reclaim funds in the event of a default. Typically a startup will need to collateralize its loan.
- Report to credit bureaus: Your lender might report negative information to credit reporting agencies which will cause damage to your business and, depending on how your loan was structured, your personal credit too. Business loan credit scoring algorithms use information like your credit history to generate a credit score that lenders typically use to evaluate your business’s creditworthiness and determine how much of a loan you qualify for.
- Hard to get future credit: Having this information reported to credit reporting agencies will affect your ability to get loans and credit in the future. Not just loans either, but a business line of credit, business credit card, and any other form of debt will be difficult to obtain.
- Settlement: Another possibility is the lender will decide to make you an offer in compromise to cut their losses and settle with you for a defined amount. This might be a lump sum or a payment plan.
If you default on a business loan, knowing your credit score will be helpful as you start to recover. You can check your business credit report with tools provided by the credit bureaus like Experian.
Finding a loan with favorable terms for your business
Biz2Credit can help merchants review financing options, find the right type of loan, and loan funder for their needs. We have the experience needed to guide your business to the ideal funding situation
Whether you are after a loan to expand your business or help you operate during tough times, Biz2Credit is a great place to start. Our helpful staff will provide you with exceptional customer service and will work hard to understand the needs of your business, the intended uses for your loan, and the best terms that can be offered. Get in touch today to find out how small business financing can help you.
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