Personal Guarantees Help You Get Approved, but Should You Sign One?
A business loan helps to fund your business, but your personal finances can also get dragged into the picture. Lenders often require a personal guarantee from business owners when a company does not have the assets or track record to borrow on its own.
Personal Guarantee Basics
A personal guarantee helps business owners get approved for a loan. To make the guarantee, you promise to pay for business debts using your personal assets, including cash, real estate, and other assets. Ideally, the business will pay off any debts, and your personal guarantee is just a safety net. But lenders are more willing if they have a personal pledge—just in case.
The guarantee: Personal guarantees are part of a loan agreement. During the application (or approval) process, lenders 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 if the loan does not get paid as agreed.
Limited liability? A personal guarantee reduces the liability protection from incorporating (by forming an LLC, S-Corp, or other entity). Business owners explicitly agree to pay off debts, so business losses can become personal losses.
Why Lenders Require a Personal Guarantee
Lenders always evaluate borrowers to predict whether or not they'll repay. For consumer loans, credit scores and other sources of information are available to help with the decision. But businesses—especially new companies or those that have never borrowed—often don't have a business-specific credit history.
With limited information, it’s hard for lenders to make a decision. They would be more comfortable if they could see that you've borrowed money in the past and consistently repaid loans. But with no historical information to aid in decision-making, lenders require some sort of security (or they charge an extremely high interest rate). That security often comes in the form of a personal guarantee. But other approaches, such as pledging business assets as collateral, may also be an option.
Without a personal guarantee, many small businesses simply can’t get loans. Banks want to improve their chances of getting paid, and they know that businesses fail all the time.
Lenders want the option to collect no matter what happens to your business. Signing a personal guarantee can also be a signal: Why should lenders take a risk if you, as a business owner, are not willing to put skin in the game?
What's the Risk?
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, such as property you own (including your home and certain valuables) or investment accounts.
Legal action: If the assets aren’t sufficient to pay off your debt, it's also 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.
Family assets: Your personal guarantee on a business loan may affect your family. Losing the house is clearly a problem. Some loans may also require your spouse’s signature so that assets held solely in your spouse’s name are fair game as well. 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 debt if you sign a “joint and several” agreement. That arrangement allows the bank to try to collect the entire balance from any or all partners who personally guaranteed business loans. If other partners can’t pay, the bank may demand the entire balance from you. Even if you aren't a 100 percent owner, you might be 100 percent responsible for the debt. Ultimately, lenders go after whoever has the deepest pockets and the ability to repay.
How to Manage Risks
Whether or not you should sign a personal guarantee ultimately depends on your ability to take the risk. It’s also wise to reduce your risk as much as possible.
Negotiate: Lenders might provide a standard agreement that asks you to sign your life away, but you can always ask for changes to that agreement. See if it’s possible to keep family assets off the table, or if you can guarantee less than 100 percent 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.
Separate yourself: 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.