Should you personally guarantee your business loan? There are risks with the rewards.
When applying for a loan, line of credit, equipment financing or business credit card, many business owners are surprised to learn that a personal guarantee is required to secure the financing.
There is nothing inherently wrong with issuing a guarantee – in fact, it is a standard for most business financing – but you should have a clear understanding of the possible consequences of personal liability on business debts.
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What is a personal guarantee?
A personal guarantee is a contractual stipulation in which you acknowledge that you're personally liable for a debt if your business can't pay it, according to Sean Messier, associate editor at Credit Card Insider.
"Personal guarantees are used to mitigate risk on behalf of lenders," Messier said. "Without a personal guarantee, if a business were to fail, then the bank wouldn't have much leverage to collect the money it initially lent."
Business owners agree to personal guarantees because they're pretty much always necessary, Messier noted.
"Businesses require much more funding than most individuals, which means that business loan amounts are often much higher than personal loan amounts, and there's therefore much more risk involved," he said. "In most cases, lending a huge pile of cash without a personal guarantee would simply be a bad business decision on the lender's part."
Keep in mind that agreeing to a personal guarantee is a calculated risk. "If you don't trust that your business can foot the bill, and you're not prepared to cover it yourself in the event of business failure, you should consider looking for funding elsewhere," Messier said.
A personal guarantee is as enforceable as any other legal agreement, and although enforceability depends on the wording of the guarantee, the lending company likely covered all of its bases when putting together the standard text of the document, said Gaurav Sharma, a former banker and founder of Bankers By Day.
What does it mean to offer a personal guarantee?
A personal guarantee from a business owner (or an executive who has a stake of at least 20% in the company) is used to secure funding by promising the lender that, if the business defaults, they will pick up the remaining debt. Most business lenders want to see that both the small business and the business owner have a strong credit history and are financially stable. For instance, the U.S. Small Business Administration requires a personal guarantor on all of its loans and has minimum credit score requirements. The stronger the credit, the better the chance of successful approval and better pricing on most financing.
Sharma noted that for some businesses, offering a personal guarantee is the only way to get access to a loan and is considered standard practice. [Read related article: How to Get Your Business Loan Application Approved]
Why do lenders require a personal guarantee?
Here are a couple of reasons why it makes sense for lenders to require a personal guarantee:
It builds trust.
Lenders want to know that you are committed to paying back the loan and that you are a responsible business owner who is personally invested in the company.
"Think of it from the bank's perspective: The owner has far more information about the business than the bank [does]," said Jim Pendergast, senior vice president at altLINE. "If he is not willing to back it unconditionally, then why should the bank risk its capital?"
It reduces the lender's risk.
If you fail to make your payments or you default on the loan, the lender doesn't have to absorb the remaining balance of the loan if you've signed a personal guarantee. Instead, the lender can go after the borrower's personal assets. Because a personal guarantee is often required of new and small businesses under a certain revenue threshold, the lender is taking a risk, and the lender's goal is to mitigate that risk.
As a rule of thumb, when reviewing a loan applicant, most lenders look at revenue to judge whether the guarantee is required. If you are a small or midsize business with revenue under $25 million a year, you'll likely be required to sign a personal guarantee. Lenders also review your business credit scores and personal credit FICO scores and analyze them for risk.
What impact does a personal guarantee have on personal and business credit?
When you offer a personal guarantee, you are putting your personal finances, credit and company credit on the line. The impact of a business loan on your credit will depend on your management of the payments and the amount of debt you already have.
If the account is reported to personal credit bureaus, the heavy debt will lower your available credit and could make it harder to take out a personal loan or mortgage.
If the loan defaults and you have a personal guarantee, the collection, charge-off and, eventually, judgments will be reported and will drastically harm your scores. (To be clear: For business financing with a personal guarantee, any negative information would be reported to both the business and personal credit bureaus.)
If you have never separated company finances from personal finances and you failed to build up company credit profiles, your business credit reports will be bare. Not only will they identify you as a high-risk borrower, but you will be more susceptible to damaged credit. Any negative information about bare profiles will wreak havoc on your scores. [Read related article: When Does Your Business Credit Score Matter?]
Unfortunately, situations like this are common, and if the business were to fail, you would be left with crippling debt and critically damaged credit. Before offering a personal guarantee, it's important to speak with an attorney to make sure you understand the differences between unlimited personal guarantees and limited personal guarantees. Here is some basic information about each type:
Unlimited personal guarantee
With an unlimited personal guarantee, you authorize the lender to collect on 100% of the loan amount and usually any legal fees that arise from your failure to pay. In other words, the lender could collect on personal assets, such as your home, vacation homes, saving accounts, cars and retirement funds. However, many states have homestead laws in place that may keep your primary home and retirement accounts off-limits to most creditors.
Pendergast offered an example of an unlimited personal guarantee. "Say two people own a business, Greg and Gertie," he said. "They take out a business loan for $100,000 with an unlimited personal guarantee. The business goes under, and Greg does the unthinkable and splits town. Gertie now has to pay the whole loan herself."
Limited personal guarantee
With a limited personal guarantee, the borrower and the lender agree on a set limit. If you were to default on a loan, you would only be responsible for that predetermined liability. In most cases, a limited guarantee is used when multiple executives with 20% or more stake in the company are personally signing for the loan.
Before you sign on the dotted line, make sure you know what will happen if you sell your portion of the business, and understand that your business model will not supersede your liability on the loan. In other words, setting up an LLC to limit personal liability does not protect you from liability in an unlimited personal guarantee.
Pendergast also gave an example of a limited personal guarantee. Consider the same scenario from the previous example.
"Gertie and Greg would split the responsibility for the loan," he said. "In this case, say they agreed to 50% each. Then, if the business goes under and Greg splits town, Gertie is only stuck paying back $50,000 and not the whole $100,000." [Read related article: What It Means to Default on a Business Loan, and What to Do Next]
What should you watch out for in a personal guarantee?
A business loan, line of credit or lease is a long-term commitment that should not be taken lightly, as it can have ramifications for you personally for years to come. Banks take on a lot of risk when issuing loans, and they want to make sure you are serious about the business and willing to risk your own financial future on it.
It is also important to remember that loans with a personal guarantee are usually less expensive (depending on the state of the business and the personal credit scores of the company), since the risk is lower for the lender.
Here are the two greatest risks of signing a personal guarantee:
Personal guarantees are difficult to get out of.
You can get rid of personal guarantees only if you sell your business and are released from the guarantee, or if you personally file for bankruptcy, said Zach Reece, a small business owner and former CPA.
There's a catch with the bankruptcy angle, however: You must file for personal bankruptcy, as opposed to business bankruptcy.
If a business files for bankruptcy, "it does not eliminate the personal guarantee unless the business is a sole proprietorship," said Randall Yates, CEO of The Lenders Network. To get rid of a personal guarantee, you will need to file for individual bankruptcy, he said.
Your financial assets are at stake when you sign a personal guarantee.
You risk your financial security when you offer a personal guarantee, warned Sherry Mae, chief marketing officer at Tankarium. When you fail to comply with the loan contract's agreement, you are personally liable for the repayment by offering properties and other nonmonetary assets as payment.
Reece echoed this warning, saying that the need for a personal guarantee is typically a sign of low or nonexistent credit history, so the lender is trying to make sure they are as protected as possible in case you can't pay back the loan. If that happens, you could be sued, and your personal assets could be seized.
Despite these risks, there's a potential upside of a personal guarantee: You could save money, as interest rates are often lower for personally guaranteed loans than for higher-risk loans.
Tracy Becker contributed to the writing in this article.