Small Business Administration (SBA) loans help small businesses and entrepreneurs get financing to start or grow a business. SBA loans often have more favorable terms than traditional financing options, but there can be severe penalties for defaulting. This article talks about the pros and cons of SBAs, the SBA loan default process, and how you can avoid defaulting on your loan.
Written by Attorney Aan Malahia Chaudhry.
Updated December 1, 2021
Small Business Administration (SBA) loans are federally backed loans granted to small businesses to help them get the financing they need to open and/or remain operational. SBA loans often have lower down payments and interest rates than traditional financing options. But there can be severe penalties for defaulting. Borrowers must personally guarantee these loans, which means your personal assets can be seized if you default on an SBA loan.
If you’re an SBA loan borrower who’s struggling to pay your loan, keep reading to learn about the SBA loan default process and about how you can avoid defaulting on your loan.
What Is an SBA Loan?
Small Business Administration (SBA) loans help small businesses and entrepreneurs get financing to start or grow a business. The SBA doesn’t lend the money directly to borrowers. Instead, these loans are made by private lenders. SBA loans are backed by the federal government and guaranteed by the SBA. This arrangement reduces the risk for lenders and also makes it easier for borrowers to gain access to these loans.
There are generally six types of SBA loans:
SBA 7(a) Loans
These are the most common SBA loans. They have long repayment terms and low interest rates. The maximum loan amount is $5 million. These loans can be used to purchase a business, real estate, or business equipment. They can also be used for working capital and refinancing.
This loan program is an umbrella term for four different lines of credits offered by the SBA. The four different lines are:
Seasonal CAPLines: As the name implies, this line of credit is best for small businesses that face seasonal highs and lows.
Builders CAPLines: This line of credit helps builders in residential and commercial real estate fund construction costs.
Contract CAPLines: This line of credit helps businesses fund costs necessary to fulfill contractual work.
Working CAPLines: This line of credit provides general funding for most operating expenses such as labor and inventory.
These are loans for up to $50,000, with terms of up to six years.
SBA Export Loans
This loan program is aimed at small businesses that are looking for business financing to expand into foreign markets or participate in international transactions.
SBA CDC/504 Loans
This loan program is geared towards small businesses that need funding to purchase or build commercial real estate that will be owner-occupied.
SBA Disaster Loans
This loan program assists in covering physical or economic disaster costs. Borrowers need to provide evidence that their business suffered negative impacts as a result of the disaster.
Pros and Cons of SBA Loans
If you’re interested in taking out a small business loan, you may be comparing several different options. SBA loans have many advantages:
There are broad eligibility requirements. To qualify for an SBA loan, your business must be for profit and be classified as a small business.
The SBA guarantees the loans. This reduces the lender’s risk. It also means that borrowers who may not qualify for traditional financing may be approved for these lending programs.
The SBA caps interest rates. Rates on SBA loans consist of a base rate and an additional percentage added by the lender. The base rate is determined by a set rate, such as the prime rate. The additional percentage varies by lender, which is why it’s important to shop around for the best rates you can find.
There are several loan options. Borrowers can choose from several different financial programs, term periods, and maximum funding amounts. This provides flexibility to choose a loan product that fits your business needs.
The SBA provides additional support and resources. These can help business owners develop their financial and business skills.
Despite the many advantages, SBA loans may not suit your small business needs due to the following disadvantages:
You may need to have equity in the business or make a down payment. SBA loans generally require borrowers to show that they have invested their own money into the business. Lenders are more willing to work with borrowers who have 10% to 20% equity in the business. This shows lenders that the borrower is serious and committed to growing their business. Conventional loans may also require borrowers to show equity in the business, but the investment requirement is often lower.
Alternatively, if you have little to no equity in the business, you may be required to pay a down payment, depending on the type of SBA loan you apply for.
Your personal assets may be used as collateral. SBA lenders may require you to give a personal guarantee by pledging your assets as collateral. That means if you default on the loan (can’t repay it), your personal property can be seized and used to pay off your business’s debts.
The approval timeline can be lengthy. SBA loans can take some time to get approved. You can speed up the process by going directly to an SBA-approved lender. By doing this, you’ll avoid the secondary approval process tied to the SBA agency. Depending on the application and the type of lender chosen, borrowers can expect to wait anywhere from half a month to over two months for their funds.
You need a decent credit score. SBA loans generally require borrowers to have a personal credit score of at least 680.
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SBA Loan Requirements
There are several requirements that the business and borrower must meet to qualify for an SBA loan.
The business itself must:
Be physically located in the U.S. and doing business in the U.S. It must also be registered, legal, and categorized as a small business. This categorization varies by industry and is usually determined by the number of employees and annual receipts.
Be a for-profit venture.
Operate in an eligible and legal industry. For instance, businesses that involve lending or gambling or those tied to religious organizations aren’t eligible. Also, anyone with greater than 20% ownership can’t be involved in criminal proceedings or be on probation, parole, or incarcerated.
The borrower and/or business owner must:
Demonstrate a valid need for the loan and show a plan for how the funds will be used.
Show that they have solid revenue projections and don’t have too much debt. This shows lenders that borrowers can afford to take on additional debt.
Have contributed money equity or time equity into the business. The amount required varies depending on the SBA loan.
Have good credit. The required minimum credit score can vary by lender but is generally around 680.
Some lenders will also consider other requirements, such as the business’s credit history and time in business. Also, some SBA loan programs have program-specific requirements borrowers must meet.
SBA Loan Default
Small business owners may find themselves unable to make their loan payments. The COVID-19 pandemic has certainly led to economic uncertainty for many small businesses. The next few sections examine the process of defaulting and offer some tips on how to avoid default.
Delinquency vs. Default
If you fall behind on SBA loan payments, you will be considered delinquent. If you continue to miss payments, then your loan will go into default. Being in default means the lender has marked you as being unable or unwilling to pay your loan. Each has different consequences.
If you’re delinquent, the lender may charge a late fee, though most lenders give a 10-day grace period before considering the payment late. The lender may also increase your interest rate, which will result in higher monthly payments. Your lender may work with you to create a repayment plan or work out another solution to avoid continued delinquency.
If you’re unable to make up the payments, the loan goes into default. Lenders generally wait 3-4 months before starting the default process. The exact timing will depend on the terms of your loan agreement. Defaulting on a loan damages your business credit status. It may even affect your personal credit score, depending on how your business is structured.
What Happens When Borrowers Can't Make Their Repayments?
Since the SBA guarantees the loan, if you default, the lender can get the guaranteed portion of the loan back from the SBA. Generally, the SBA guarantees up to 85% of the loan amount for loans under $150,00 and 75% of the loan amount for loans over $150,000.
If you personally guaranteed the business loan, you made a legal promise to repay it using personal or business collateral. When you sign a loan with a personal guarantee you’ll specify assets as collateral, such as your house or business equipment. The lender can recover these assets to repay the debt if you default. Lenders may also garnish your wages or foreclose on your home if you used it as collateral. The specific rules for collection differ by state and lender.
If the collateral doesn’t fully repay the loan, the lender can file a claim with the SBA to cover the guaranteed portion. If this happens, the SBA will send you a 60-day demand letter telling you to repay the amount it paid to the lender. The demand letter will generally contain an offer in compromise. An offer in compromise is essentially a settlement. If you pay the offer in compromise, you get to settle the matter for less than the full amount you owed.
You have 60 days to respond to the demand letter. If you don't respond, your debt will be sent to the U.S. Treasury Department. The department can collect your debt using wage garnishment, Social Security benefits garnishment, a bank account levy, or your federal income tax refunds.
Avoiding SBA Loan Default
If you’re struggling to make your loan payments, it’s important to communicate with your lender. Contacting your lender early shows that you’re transparent and willing to work toward a solution. Your lender may be willing to work with you to create a modified repayment plan that helps you avoid defaulting on the loan.
SBA loans are backed and guaranteed by the federal government. They have many benefits for small business owners, including a variety of loan programs to meet different business needs, interest rate caps, and broad eligibility requirements. That said, borrowers should also take into account that it can take a long time to get approved for an SBA loan and that you may need to personally guarantee the loan with personal or business assets. You risk losing these assets if you default on the loan.
It’s important to understand the details of your SBA loan agreement so you can protect your business and personal assets if you hit a financial rough patch and struggle with repayment.