A business loan helps to fund your business, but it can be challenging to get without having established a credit history for your business. When a company does not have the assets or track record to borrow on its own, lenders can require a personal guarantee from business owners. Signing a personal guarantee for a business line of credit can drag your personal finances into the picture.
What Is a Personal Guarantee?
A personal guarantee helps business owners get approved for a loan if the business doesn't have its own credit rating. To make the guarantee, you promise to pay for business debts using your personal assets, including cash, real estate, and other assets or investments you might have.
Ideally, the business will pay off any debts, and your guarantee is just a safety net. But lenders are more willing to let companies borrow money if they have a personal pledge.
Personal guarantees are part of a loan agreement. When completing the application or during the approval process, lenders may require business owners to sign a document that details how the lender can collect if the business fails to pay off the loan.
What You Pledge
A personal guarantee can be secured or unsecured, depending on your lender. You may have to pledge specific assets, such as a home, or funds held in financial institutions.
Assets and Credit
In addition to assets that you pledge, your personal credit is on the line. Your credit score can drop if the loan does not get paid as agreed.
A personal guarantee reduces the liability protection from incorporating, such as if your business was set up as an LLC, S-Corp, or other entity. Business owners explicitly agree to pay off debts, which means business losses can become personal losses.
Why Lenders Require a Personal Guarantee
As part of the underwriting process, lenders must evaluate borrowers to determine whether or not they'll be able to repay the loan. Lenders also assess a company's assets to be used as collateral, including the owner's personal assets. Companies that don't have sufficient collateral to back up the loan may be required to provide a personal guarantee so that the lender has some recourse in case of nonpayment or default.
Sometimes, there's a lack of credit history. For consumer loans, credit scores and other sources of information are available to help with the decision. New businesses or those that have never borrowed often don't have a business-specific credit history. In other words, there's not enough of a track record of payments to establish them as a reasonable credit risk.
With limited information, it can be challenging for lenders to make a credit decision, and banks want to improve their chances of getting repaid in case the business fails. Lenders would be more comfortable if they could see that you've borrowed money in the past and consistently repaid loans. However, with no historical information to aid in decision-making, lenders may require some security, charge an extremely high-interest rate, or both.
The security a lender may require may include a personal guarantee. However, other approaches, such as pledging business assets as collateral, may be an option. Without a personal guarantee or valuable business assets, a business may not qualify for the loan.
The Risk of a Personal Guarantee
When you provide a personal guarantee, you allow a lender to pursue you personally if you can't repay a business loan. That can mean different things, depending on your loan agreement. As part of the guarantee, you might have given the bank permission to take assets, including your home, valuable items, investment accounts, or other personal or real property you may own.
If the assets aren't sufficient to pay off your debt, it's likely that lenders can take legal action against you. A judgment would damage your personal credit and make it difficult to borrow in the future. Plus, defaulting on a loan can make it harder to get a job, buy insurance, or rent a place to live.
Your personal guarantee on a business loan may affect your family. Some loans may also require your spouse's signature so that assets held solely in your spouse's name can be used to repay the borrowed amount. Otherwise, you might be tempted to transfer assets to your spouse's name to borrow risk-free.
Paying for Partners
If you have partners, you may be on the hook for more than your fair share of the debt. If you sign a joint and several agreement, you and your partners are bound jointly as one party and also severally as separate parties at the same time. This type of arrangement gives the bank permission to try to collect the entire balance from any or all partners who personally guaranteed the loan.
If other partners can't pay, the bank may demand the entire balance from you. Even if you aren't a 100% owner, you might be 100% responsible for the debt. Ultimately, lenders go after whoever has the deepest pockets and ability to repay.
Should You Sign a Personal Guarantee?
Whether or not you should sign a personal guarantee ultimately depends on your ability and willingness to take risks. Generally, it's wise to reduce your risk as much as possible, but everyone has a different tolerance when it comes to taking chances.
Lenders might provide a standard agreement, but you can always ask for changes to that agreement to reduce the risk you take. Ask if keeping family assets out of the deal is a possibility or if you can guarantee less than 100% of the loan amount. The better your loan application, the more negotiating room you'll have, so paint a clear picture of why your business will be successful and how you'll have no trouble paying off the loan.
It's best to move away from personal guarantees as your business evolves. Once you build credit for your business and gather assets for collateral, you can stop guaranteeing loans personally. In the meantime, minimize your risks by borrowing wisely.