Default on bank loans – how to avoid and what to do when it happens

Obtaining financing from banks is one of the most common ways a company can extend its cash and expand its business. Building a relationship with a bank also benefits businesses because banks do not just extend the company’s lifeline, but they also serve as unpaid financial advisors whose advice may become most valuable when your business face tough times. It is not unusual for businesses to go through difficult times and be unable to meet all obligations, including bank loans. It is thus a sad realisation that while you have been working hard for your business to succeed, you have been backsliding in your debt payments. 

Default on bank loans – how to avoid and what to do when it happens

How to avoid bank loan defaults

Create a viable business plan. 

Before lending you the money, the bank assesses your business, taking into consideration your growth, future profitability, existing assets, and existing liabilities. One of the ways to avoid a bank loan default is to create a viable business plan, one that ideally includes profit and loss budget and cash flow forecast, and submit this plan to the bank at the time you are applying for a loan. Banks assume risks but only to the extent that the risk is something they can cushion. 

Start with a smaller loan. 

There are many types of loans offered by banks, including secured and unsecured loans. Young businesses often have a hard time qualifying for loans so banks require them to provide a form of security, usually a real property, like a building or land. Defaulting on a bank loan then does not just halt the flow of additional cash to your business but may also result in you losing a precious property. It is thus best to start applying for a smaller loan and build your credit history from there.

Review the loan contract. 

Most loan contracts will be in writing to protect you and the bank. It is advisable to review the loan contract, especially the loan conditions and the triggers for default. The loan agreement will also indicate the payment interval, the interest to be paid, and any one-off or ongoing fees that accompany the loan. Because the bank is a business, its goal is to seal a deal with a client and create a long-lasting relationship with that client. Use this to your advantage by seeking clarifications before committing wholly to the loan agreement. While the Australian Securities and Investments Commission has, in recent years, called for major banks to create fair loan contracts for SMEs, it is still best to make the due diligence yourself and review the loan agreement independently.

What do you do when you default on bank loans

When the inevitable happens, and it does happen even to the most profitable of businesses, immediately inform the bank. You should take note though that there is a difference between not being able to pay on time, and not being able to pay at all or you fail to perform your obligations under the loan agreement. The former is called delinquency, the latter is called default. Both can arise from inability to pay but each one has a different consequence to the loan agreement. While delinquency may result to a mere payment of interest, default, which can also arise from prolonged delinquencies, may result to foreclosure of the property securing such loan or a more complicated legal proceeding seeking payment of the debt.

Be forthright with your bank. Tell them everything there is to know, both positive and negative, about your business and your business activity. As soon as you report that you are unable to perform any obligation under the loan agreement, the bank will conduct an investigation and look into your financial records and forecasts, review your business plan, talk with you about the challenges you are facing, and find out your plans for recovery. This investigation should help the bank make an informed decision on how to proceed with your loan transaction. There are four scenarios:

  1. The bank may pursue immediate enforcement action.
  2. The bank may give your business more time to recover.
  3. The bank may accept varied payment plans.
  4. In special circumstances, the bank may grant an additional loan or line of credit.

This article from RSM provides more details on how a bank conduct investigations on businesses with respect to bank loans.

Take the bank’s investigation seriously because the bank can make a recommendation that has a wide effect on your business – either the bank can cancel the loan or offer further finance. If your business is doing good, there is nothing to worry about as long as you inform the bank and discuss with the bank your options. If your business is not doing good, be candid and seek the advice of the bank on the steps to take.