What Happens When You Default on a Loan? Plus, How to Avoid It

Rieva Lesonsky

Rieva Lesonsky

Contributor at Fundera
Rieva Lesonsky is a small business contributor for Fundera and CEO of GrowBiz Media, a media company. She has spent 30+ years covering, consulting and speaking to small businesses owners and entrepreneurs.
Rieva Lesonsky

When you take out a small business loan, you have the best of intentions to pay back the loan on time and in full. But, sometimes things don’t quite work out the way you planned. If your business is going through a temporary rough patch, you might find it difficult to afford your loan payments.

This puts you in risk of loan default and can affect your credit history and have other major consequences. It’s critical to handle this situation in the best way to protect yourself and your future access to capital. Although the specifics vary depending on your lender, type of loan, and loan agreement, here are some general guidelines about what to expect in the event of a loan default and how to avoid a loan default in the first place.

What Is the Loan Default Rate?

The Federal Reserve maintains data on loan default rates across a range of loan types. There are typically fewer defaults on business loans, compared to consumer loans, because lenders have higher qualification standards for business loans. In the fourth quarter of 2018, 0.94% of borrowers defaulted on commercial and industrial loans. In contrast, 2.34% of consumer loans went into default. Defaults are more common on credit cards, with an average loan default rate of 2.54%.

The data from the Federal Reserve only includes bank loans. Online business loans from alternative lenders tend to have lower qualification standards. As a result, these loans typically have higher default rates.

What Happens When You Default on a Loan?

The circumstances that trigger loan default will vary based on your lender and type of loan. Some lenders count one missed payment as a default. However, most wait until you’ve missed multiple payments, there are insufficient funds in your bank account to collect the payment, or until a payment is at least 30 days late before considering your loan to be in default.

As soon as your loan goes into default, the lender will contact you. As time goes by, your lender will become more aggressive. The lender’s remedies will vary based on the specifics of your loan agreement, but here are the general loan default consequences:

  • Lower credit score – The lender will report each missed payment to credit bureaus, which can hurt your credit score. The more payments you miss, the more damage will be done to your credit score. Late payments and collections stay on your credit report for up to seven years.
  • Legal claims – Your account might be sent to a collections agency and you might start getting a lot of collection calls. At some point, the lender might sue you to collect on the debt or to liquidate any collateral you’ve provided in exchange for the loan. Such legal claims can be time consuming and expensive.
  • Higher expenses – Defaulting on your loan can trigger late payment fees. In addition, since your credit score has taken a hit, any future loans that you get will have higher interest rates.

Specifics vary based on the type of loan you have. When you sign your loan agreement, it might include a personal guarantee to pay back the loan, or you might provide collateral in exchange for the loan. Let’s take a closer look at what happens when you default on different types of loans.

What happens when you default on a loan?

Defaulting on a Secured Loan

A secured loan is one in which you put up collateral for the loan. Examples include equipment loans and commercial real estate loans. If you default on the loan and can’t work out some type of agreement with the lender, the lender will seize the collateral, liquidate it, and take the money. In some states, lenders can seize the collateral without a court judgment. In others, the lender first has to secure a court judgment allowing them to seize the collateral. 

Keep in mind that most lenders want to avoid seizing collateral because it takes time and resources to pull off. They prefer to work out a payment plan or some other kind of solution.

Defaulting on an Unsecured Loan

An unsecured loan is one that doesn’t require you to put up specific collateral. Many business loans that you can get online are unsecured. However, note that even if a loan is unsecured, the lender will usually require a personal guarantee from the borrower or will place a general lien on all business assets.

Once you miss a payment, the lender will generally begin charging late fees and might also raise the interest rate on your unsecured loan. If they can’t collect on the loan, they’ll likely file a lawsuit against your business. Depending on the terms of the loan, they might be able to garnish some money from your business bank accounts or seize business assets such as vehicles, equipment, or real estate your business owns.

Defaulting on an SBA Loan

Here’s where things can really get ugly. Banks make SBA loans, but a percentage of the loan amount is guaranteed by the U.S. Small Business Administration (SBA), an agency of the federal government. If the bank can’t collect on the loan, the federal government will step in.

First, the bank will try to collect on the loan under the terms of the SBA loan agreement. SBA rules require most loans to be backed by adequate collateral. So, the lender will start by seizing business and personal assets that were pledged as collateral or through a personal guarantee. If this still isn’t enough to pay off the loan, the lender will file a claim with the SBA to collect the amount that the SBA guaranteed.

Dealing with the SBA after an SBA loan default is kind of like dealing with the IRS when you haven’t paid your taxes. The SBA will ask you to either pay off the remainder of the loan within 60 days or to make an Offer in Compromise—an offer to pay a percentage of what is owed. The SBA then examines your business finances to see if they’re willing to settle for your Offer in Compromise.

If not, the U.S. Treasury Department takes over. The Treasury can collect the balance owed by garnishing tax refunds, bank accounts, wages and more for as long as it takes to get the money back.

what does it mean to default on a loan

Avoiding Loan Default: Proactive Measures to Take

Since loan default can affect your credit and finances and limit your access to financing in the future, it’s best to try to avoid getting to this point. Sometimes, there’s no alternative to loan default, but it’s best to keep your options open.

Here are the steps to take to avoid loan default:

  1. Contact the lender right away – If you are struggling to make your loan payments, you should contact the lender right away. The lender might be able to extend your loan term, defer some payments, or arrange a payment plan with you. And if you keep an open line of communication, the lender is more likely to be understanding and avoid collection efforts. Be ready to answer questions about your business and personal income, and be sure to document the terms of any payment plan in writing.
  2. Pay what you can – Even if you can’t afford the entire payment, making smaller micropayments will help you avoid a full-blown default. The lender, seeing that you’re making a good faith effort to pay back the loan, might be more amenable to a payment plan.
  3. Consider seeing a debt counselor – If you’re really struggling beneath a heavy load of debt, you might want to consider making an appointment with a debt counselor or credit counselor. They can get you on a debt management plan and give you strategies for paying down debt.
  4. See a bankruptcy lawyer – Sometimes, when a business owner defaults on a loan, bankruptcy isn’t far off. Bankruptcy can have even bigger implications than default for your credit and finances. If you’re consider filing for bankruptcy, contact an experienced bankruptcy attorney to walk through your options.

Once a loan falls into default or collections, the status will show up on your credit report within one credit cycle (about 30 days). If you pay off the account after that, the negative marks won’t automatically come off your credit report. Defaults and collection items can stay on your credit report for up to seven years. Fortunately, their impact decreases over time, and the lender might remove them sooner as a sign of good will.

loan default definition

Moving Forward After Loan Default

Defaulting hurts your credit score, makes it harder to borrow money in the future, and can even lead to business and personal bankruptcy. Before you ever borrow money, make absolutely sure you have a plan for paying it back.

As soon as you find you’re at risk of missing a payment, contact your lender. Lenders hate surprises, and if you’re open about the situation, many will work with you to help you make up missed payments and get your account back in good standing. And if your loan does end up in default, you can come through to the other side. Seek the help a debt counselor, cut back on spending, and find ways to ensure that you’re more in control of your finances in the future.

Editorial Note: Fundera exists to help you make better business decisions. That’s why we make sure our editorial integrity isn’t influenced by our own business. The opinions, analyses, reviews, or recommendations in this article are those of our editorial team alone. They haven’t been reviewed, approved, or otherwise endorsed by any of the companies mentioned above. Learn more about our editorial process and how we make money here.
Rieva Lesonsky

Rieva Lesonsky

Contributor at Fundera
Rieva Lesonsky is a small business contributor for Fundera and CEO of GrowBiz Media, a media company. She has spent 30+ years covering, consulting and speaking to small businesses owners and entrepreneurs.
Rieva Lesonsky

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