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HomeLoansThe ABC’s of Loan Default

The ABC’s of Loan Default

If a borrower has defaulted on a loan by not paying the EMIs for a certain amount of time (approximately 90 days or more) then this loan is referred to as a bad loan or a non-performing loan (NPL).

Table of contents

  • Loan Default and Loan Delinquency
    • Types of Loan Default
  • Bad Debt
  • Effect of Business Loan Default on Credit
  • Consequences of a Business Loan Default
  • Conclusion

Loan Default and Loan Delinquency

When a debtor doesn’t fulfill their contractually owed legal obligations, default occurs. For instance, a debtor might have missed a payment or broken one of the debt contract’s loan covenants. Failure to repay a loan is referred to as a default.

When the likelihood of loan recovery is reduced to zero i.e., when there is no chance of the loan being repaid, a delinquent loan becomes a defaulted loan. 

Delinquency is monitored because it signals a higher risk of loss, is indicative of operational issues, and could help lenders estimate how much of the portfolio will ultimately be lost due to non-repayment.

Types of Loan Default

Listed below are the two types of defaults:

  1. Wilful Default – When you have good financial standing and the ability to pay back your EMI but decide not to, this is referred to as wilful default. Your credit score and future ability to obtain a business loan will be negatively impacted by this in the long run. In certain cases, a criminal case may also be filed against you
  2. Non-Wilful Default – If you fall behind on a loan due to events beyond your control, such as a failed business deal or losing your job, this is regarded as a non-wilful default.

Bad Debt

When a debtor defaults on a payment, the creditor is forced to write off that amount of money as a bad debt. Bad debts are recorded as charge-offs when they become uncollectible and are present on a creditor’s books.

Every company that offers credit to customers must plan for the possibility of bad debt because there is a chance that the money won’t be returned. 

Effect of Business Loan Default on Credit

A series of unfavorable events might occur if you default on a business loan or any other loan for that matter. Your loan could be accelerated by your lender, which would result in you suddenly owing the entire loan balance rather than just the remaining monthly payments.

Lenders might file a lawsuit to get their money, which could involve taking possession of property, whether it be private or business-related. Additionally, your credit score will get severely impacted which will hinder your ability to get loans in the future.

A business loan default may, in some cases, also have an impact on your personal credit. The following three elements could determine whether your business loan default will affect your personal credit and how:

  1. Business setup – Depending on how your business is set up, a business loan default will almost certainly have an impact on your personal credit if you are a sole proprietor.
  2. Structure of your loan – Even if you aren’t a sole proprietor, using your personal credit to apply for your business loan could have negative effects on it. For Small Business Administration (SBA) loans and startup loans given to companies with little credit history, personal guarantees are frequently required. Check your loan documents if you’re unsure whether your personal credit was used to guarantee the loan.
  3. Handling of your loan default – If your loan default ultimately results in business bankruptcy and your personal assets are in jeopardy, you might want to think about filing for personal bankruptcy as well. Naturally, declaring bankruptcy will have a significant effect on your personal credit. If you find yourself in this situation, it may be beneficial for you to seek advice from an experienced bankruptcy lawyer.

Consequences of a Business Loan Default

Every entrepreneur has, at some point or another, thought about or actually obtained a business loan.

However, if you have not been able to pay your monthly installments on time due to circumstances like a sudden decline in sales, incorrect calculations, or other unanticipated events, your credit rating will get negatively affected.

Depending on the terms and conditions of the trade agreement, different consequences can result from defaulting on a business loan. They might also impact your credit rating. The repercussions of defaulting on your business loan are listed below.

  1. Drop in credit score – Credit score gets lowered because you are reported to the credit bureaus each time you miss an installment by the lender. Your credit score will suffer as a result, which will increase the likelihood that you will be granted a loan in the future.
  2. Higher loan interest rate – Depending on the terms of your business loan agreement, your interest rates may increase once your credit score declines or you may be charged with an additional late fee. Both your current loan repayment and potential future loan approvals may be impacted by this.
  3. Foreclosure or legal action – If you have a secured loan, a foreclosure will give the lender complete possession of all the assets listed as collateral in your loan agreement. To recoup their losses, they frequently sell the collateral at a closed-door or open auction. You typically pay a late fee to the lender when you have an unsecured loan. The lender demands a personal guarantee for your company’s assets even for unsecured loans. Therefore, if you continue to default, the lender has the right to sue you and your company.
  4. Approval challenges for future loans – If you default on a loan and have a low credit score, it will be very challenging for you to obtain any loans in the future. You’ll need to look for alternative sources of funding for your company.
  5. Declaration of bankruptcy – The lender may file a lawsuit to recoup their money. The collateral may be taken in the case of a secured loan. Your company might have to file for bankruptcy if the lender is still unable to recoup the loan balance.

Conclusion

A bank loan for a business and credit from investors through crowdfunding, angel investing, etc. are the two main sources of credit for businesses. If you can’t make payments on a loan from an investor, you can try to negotiate a longer repayment period. The extra time can be used to pay off debts.

In the event of a default, the borrower is subject to the standards of a licensed lender and must proceed with caution. However, by being proactive, the borrower can take some steps to reduce the negative consequences of defaulting on a loan.

Therefore, always ensure that your payments are on time when it comes to managing your debt. Doing nothing is not an option if you are unable to repay your loan.

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