From a lender’s perspective, loaning money to a business can be risky. If the business can’t handle the payments, the lender is stuck without a way to recoup the money. That’s where personal guarantees come in.
A personal guarantee on a loan is a commitment you make to personally repay the borrowed money if your business can’t. It offers lenders an extra layer of protection because you effectively become the co-signer on your business loan. Personal guarantees are fairly standard for most small business loans, so be prepared to sign one if you want to qualify for business financing. Here’s what to look for.
How does a personal guarantee work?
A lender will tell you whether you need a personal guarantee during the application process. They may ask for one if your business is brand-new, has little to no credit history, or shows signs of financial instability. Each of these situations presents risk for the lender, and a personal guarantee lessens that risk.
In some cases, the lender may ask you to put down a personal asset, such as your home or personal savings, as part of the personal guarantee. If you later default on the loan, the lender could legally take the collateral, sell it, and use the funds to pay off your loan balance. This is also known as a secured personal guarantee.
Some companies don’t have assets to pledge, so the lender may offer an unsecured personal guarantee. If you later default on the loan, the lender may sue you for repayment, not just the business.
Another option is finding someone who’s willing to co-sign the loan. The co-signer might sign a secured or unsecured personal guarantee. Either way, they’re equally liable for the debt if you can’t handle the payments later on.
Pros and cons of personal guarantees
Like any financial product, there are some benefits and drawbacks to signing a personal guarantee on a business loan:
- Better chances of qualifying: Signing a personal guarantee could make it easier to qualify for the loan itself. In some cases, it might be the only way to qualify for a business loan.
- Better loan terms: Borrowers also tend to receive more favorable interest rates and repayment terms when signing a personal guarantee.
- You’re liable for the debt. If your business defaults on the business loan, the lender can go after you personally for the debt. Your personal credit could suffer, and you may lose collateral tied to the guarantee.
- Your family members may be on the hook for the debt, too. In community property states, a business creditor of one spouse can go after the assets and income that belongs to the “community,” or the married couple, to pay down the loan balance.
- Your business structure likely won’t protect you. Some business structures protect the business owners against personal liability for most of the company’s debts. However, things change if you or a partner signs a personal guarantee. You’ll be personally on the hook in the event your company doesn’t pay its bills.
When a personal guarantee might be required
Lenders will likely require a personal guarantee when your business is new. The lender takes on risk when it extends credit, especially when a business hasn’t been around very long. A personal guarantee offers some protection for the lender because if you walk away from the business, you’re still legally bound to repay the loan.
You’ll also need to provide a personal guarantee if you’re applying for a Small Business Administration loan and you own 20 percent or more of the business.
How personal guarantees could impact your credit
Personal guarantees don’t typically appear on your credit reports, so they won’t impact your credit as long as you follow the terms of the agreement.
But if you default on the loan, the lender may report the delinquency to the credit bureaus. That negative information can stay on your personal credit reports for up to seven years and on business credit reports for six years and nine months.
These negative marks could drag down your business credit and personal credit, making it harder to apply for future business financing. And if you do qualify for a business loan or credit card down the road, you may have to pay higher interest rates on what you borrow.
Types of personal guarantees
When you sign a personal guarantee, it may be “limited” or “unlimited.” The difference depends on the extent of your liability and how long the guarantee applies.
Unlimited personal guarantee
If you sign an unlimited guarantee, then you’re obligated to repay the loan in full, including fees and interest. Some lenders require business owners to pledge their personal assets, such as a home, as collateral.
Limited personal guarantee
A limited personal guarantee limits your obligation to just a portion of the loan if the business defaults. For example, the guarantor might be released from liability when:
- The loan balance or loan principal drops below a certain level
- The business pays off a certain dollar amount or a certain percentage of the loan plus interest and other costs
- A certain amount of time has passed
What to look for in a personal guarantee
Before signing a personal guarantee, look for these red flags:
- Guarantee conversion: In some cases, a clause in the loan agreement allows the lender to convert a limited guarantee to an unlimited personal guarantee.
- ‘Bad boy’ clause: Sometimes known as “carve-outs,” these kick in when the borrower does something illegal or unethical. For example, the negative action could trigger a guarantee conversion.
- Vague language: You expose yourself to risk if any language in the contract could be interpreted in more than one way.
- Continuing guarantee: These apply to any future contracts you have with that lender. Ask your lawyer whether these seem reasonable, based on the language in the contract.
- Joint and several guarantees: These clauses make all business owners equally liable for the debt. So if your business defaults on the loan, the lender could come after you for the full amount of what’s owed even if other partners (and not you) gave a personal guarantee.
Take these steps before signing a personal guarantee
- Have a lawyer review the contract. If reading through legal documents isn’t your strong suit, then it’s worth hiring a lawyer or other professional who can explain the terms of your agreement—before you sign it. Ask questions about unclear language.
- Consider your own limits. Before signing a personal guarantee, figure out how much risk you’re comfortable accepting on behalf of your business.
How to avoid personal guarantees
If you want to avoid signing a personal guarantee, your main option is building business credit. A strong history of repaying business loans and credit cards on time makes it easier to qualify for the loan and potentially get the personal guarantee waived altogether. You might have better luck with the negotiation if you offer a larger down payment, accept a higher interest rate, or borrow a smaller amount.