A loan is a convenient way for businesses to reinforce their financials. A wide variety of business loan products are available for businesses of all sectors, shapes, & sizes in the Indian market. Flexible tenures, competitive rates, and products tailored to business needs are the biggest reasons business loans enjoy such prominence. Under ideal conditions, a business loan from a bank or NBFC can help a company grow and profit bigger, and the business gradually pays the debt per the loan agreement.
However, as economic conditions become more fragile & uncertain and mass psychology becomes more & more fleeting, continual success is no longer a guarantee. Sales may flounder, profits may drop, and unforeseeable circumstances may make things extremely challenging. Even the most farsighted & intelligent decisions may not work, to say nothing of wrong and miscalculated ones.
When a business’ financials falter, liabilities become a nightmare, and the chances of a loan default become high. And the consequences of a business loan default can be devastating.
What Happens If You Default on An Unsecured Business Loan in India?
Any collateral does not back up unsecured loans in business; that is, not secured against default by any business assets. Default on an unsecured business loan can result from many factors, including wilful defaulting by a business.
So, what counts as a business loan default?
Definition of Loan Default:
When a borrower fails to make timely repayments for their loans, thereby breaching the terms of the loan agreement, the lender reports a loan default. In such cases, the lender can take stringent steps and pursue legal action to mitigate losses and recover the borrowed amount.
Banks and non-banking financial institutions in India categorise defaults as: wilful and non-wilful.
- Wilful default occurs when, despite being in a strong financial position, a business reneges on the loan agreement terms and does not make timely adjustments. Wilful defaulting can have a drastic impact on the creditworthiness of a business and its ability to acquire loans in the future.
- Non-wilful defaults happen when poor sales, volatile market conditions, and major losses weaken a business’s finances, rendering them unable to make payments on time.
So, what happens if you default on a business loan? Well, the repercussions can be damaging for a business.
Results of Defaulting on a Business Loan
In India, banks and NBFCs look into several factors to determine a business’s eligibility for a loan. And it is also these factors that the lending institutions consider while determining the steps towards remediation in case of default. Irrespective of the steps enforced, the consequences of defaulting on a business loan WILL detrimentally affect the reputation & continual operations of a business.
1. Drop in Credit Scores:
Even a single missed EMI payment can be considered a default and affect a business’s credit score badly. Poor debt management can harm a business’s reputation, bring down credit scores and negatively impact its chances of future loan approvals.
2. Increased Rate of Interest:
If lending institutions find any instances of loan default in the past and/or a poor credit score, they will levy substantially high-interest rates. Sometimes, they might even charge a ridiculously high late fee for late loan payments. All such actions affect not only the current loan repayment procedure but also any future business loan approval.
3. Legal Action or Foreclosure:
Business loan defaults are grounds for lenders to pursue legal proceedings against the borrower. They may foreclose the loan though the legal actions can depend on whether the business loan is secure or not.
In the case of secured loans, borrower breaches can compel lenders to acquire the collateral used as security for the business loan. They become the legal owners and gain complete authority over all the assets & properties used as collateral. Those assets can then be liquidated or sold off via auction.
For unsecured loans, missing loan payments may lead lenders to charge exorbitant late charges. However, most Indian banks and NBFCs will require business owners or loan applicants to sign a personal guarantee to avail of an unsecured loan. They may even ask for a lien on the business’s assets. In case of business loan default, the lending may claim legal claim to those assets and hold the personal guarantor liable.
4. Difficulty in Getting Approved for Loans in the Future:
Corporate debt is a serious issue in India, More than Rs. 10.52 trillion in corporate debt may default over three years, per Business Standard’s report. Defaulting on a business loan and lower credit scores can severely impair a business’s ability to get loan approvals in the future.
5. Declaring Bankruptcy:
When an organisation becomes financially insolvent, creditors undertake legal proceedings to recover any debt. For a secured business loan, assets are seized for private or public auction. However, the company may need to declare bankruptcy if asset seizures and other recovery tactics are insufficient to secure the total debt amount.
In cases of bankruptcy, when even assets are not enough for loan recovery, personal liability issues may arise. Similarly, for an unsecured loan, the personal assets of the loan guarantor may be seized for recovery.
The pitfalls of defaulting on a business loan, irrespective of whether it’s a secured loan or an unsecured loan, can debilitate a business. With external financial support, defaulting businesses may be able to restore everything to normal.
Ways to Avoid Defaulting on a Business Loan
Efficient financial planning, foresight, agile business strategies, a finger on the market’s pulse, and staying one step ahead of the competition are essential for sustaining a business & ensuring all debts are paid on time.
In addition to the above, here are some effective ways of avoiding any business loan default.
1. Maintain Reserves:
A business must have enough working capital to repay its debts per agreements. Businesses should maintain sufficient balance in their bank account to compensate for uncertain market conditions or unforeseen circumstances. At least 3 months of financial reserves are a must to ensure proper financial security against all liabilities.
2. Diligence about Due Dates:
Companies must deal with their debts with diligence. Due dates of monthly payments, interest rates, amount of instalment payments, late fee, etc.- business owners must keep all such aspects in mind. They need to maintain their business and, if necessary, even their personal finance to ensure timely monthly payments.
Owners must keep track of the repayment schedules and set reminders of due dates. Proper cash flow forecasting is also a great way to ensure timely loan repayments.
Refinancing is a great way to ease the burden of stringent & unfavourable loan agreements. Suppose the current debt financing avenue is causing cash flow issues. If the expenses incurred affect monthly payments or a drop in sales is straining business and personal finances, refinancing can help big time.
Refinancing involves seeking a different loan product and being used to prolong loan tenures and lower interest rates. However, it is only a precautionary measure and not a solution.
4. Reschedule Debt:
Businesses can consult with their current lender regarding loan rescheduling if debt management is under the current circumstances. While this may affect the credit score, debt rescheduling is a better option than defaulting. They can reduce interest rates and increase loan tenure, making instalment payments easier.
5. Prioritise Debt Repayment:
Debts and liabilities must always be a top priority for a business. Repaying what is owed promptly can save from all the hassles, improve creditworthiness, boost business reputation, and chances of acquiring loans with better terms in the future.
6. Communicate with Your Lender:
It is wise to be proactive and talk with lenders if cash flow issues & other financial problems begin to arise. Lending institutions always appreciate such communication and make repayment terms more favourable.
7. Manage Expenses and Prioritise Debt:
Effective financial planning is of paramount importance. Businesses should always keep a check on expenses & investments and have substantial capital to clear all debts as per the business loan agreement. Debt repayment must be the top priority amongst all monthly financial transactions. Finally, it is always best to borrow only when necessary.
8. Seek Legal Assistance:
Support from a legal firm can be extremely beneficial if there’s no way to avoid defaulting. Their legal advice can help businesses understand their rights, identify opportunities, and take the next best step.
How Defaulting on a Loan Impacts Your Business
If a business defaults on a loan, lenders can initiate several actions against the defaulter, most prominent among which are:
1. Seizing Assets in a Default
A secured business loan is backed by collateral, which the bank may liquidate, sell, or auction off in case of default. The proceeds are then used to recover as much of the business loan amount as possible. Asset seizure and subsequent liquidation are the most probable actions taken.
2. Business Loan Acceleration
Lenders can also accelerate the repayment procedure if they think the chances of defaulting are high. They may ask the business to repay the loan amount per agreement and at a specific interest rate. Loan acceleration can benefit a business by paying a lump sum and clearing the amount the lender asked for. The lender may not consider any default, and the credit score remains unaffected.
What is a personal guarantee?
Personal guarantees hold business owners & executives liable for clearing all debts. In insolvency, the guarantor can be held legally responsible by the lender.
Can I secure a business loan with a guarantor?
Yes, a guarantor can act as a security for obtaining a business loan. Typically, a person having at least 20% ownership of a business can stand in as a loan guarantor.
How can you protect your business when you default on a business loan?
Seeking legal advice, holding talks with lenders, selling off assets, and accelerating repayments are effective ways to shield your business against the consequences of a business loan default.