If you’re approved for a small business loan, you’ll have to sign a lengthy loan agreement before receiving the proceeds. While reviewing the document, you may notice that the lender requires a personal guarantee (which means you assume personal liability ) to execute the contract. But what does this mean for your personal finances?
Keep reading to learn more about what a personal guarantee entails, how it could impact your finances, and if you should explore financing alternatives that don’t require a personal guarantee to receive funding.
What is a Personal Guarantee?
As the name suggests, a personal guarantee provides assurance to the lender that you’ll repay any business debt using personal assets (and not business assets) if the business is unable to repay what’s owed. Basically, this means the small business owner will be personally liable for the debt, or the business lender has the right to take legal action and go after your assets to recover any money that’s owed.
Business loans often require personal guarantees to offset the risk of loss. Even if your business is financially stable and you have a solid credit history, there’s no way to know if it will continue to thrive over time. The lender still needs to get paid, hence the need for a personal guarantee to ensure the amount you borrow is repaid in full.
Limited vs. Unlimited Personal Guarantee
There are two types of personal guarantees to be aware of:
- Limited personal guarantee: A limit on the amount the lender can collect from the borrower if the business defaults on the loan agreement. Limited personal guarantees are common in agreements between several business partners.
- Unlimited personal guarantee: This type of guarantee allows the lender or creditor to recover the entire outstanding loan amount and any legal fees incurred during the collection process.
An Example of a Personal Guarantee
To illustrate how an unlimited personal guarantee works, assume you take out a $100,000 business loan. After a few years of payments, you still owe $48,000 to the lender, but unforeseen circumstances limit your ability to repay the remainder of the funds. The lender is unable to reach a payment arrangement with you, so they take you to court and win a judgment against you. If they incur legal fees of $6,000, this amount is added to your remaining balance, and you’ll owe a total of $54,000.
The financial institution can seize this amount from your business or personal assets to settle the outstanding loan balance.
Do Personal Guarantees on Business Loans Affect Your Personal Finances?
As mentioned above, personal guarantees on business loans only affect your personal finances if you default on the loan. The lender can seize your personal assets to recoup what’s owed, but the amount they’re entitled to depend on whether you have an unlimited or limited personal guarantee.
Do Personal Guarantees on Business Loans Affect Your Personal Credit Rating?
If you break your promise with the lender to repay what you borrow on a business loan, your credit rating could be negatively impacted. Even if the loan wasn’t originally reflected on your personal credit report, defaulting means the lender may report the delinquent account to the three major credit bureaus – Experian, TransUnion and Equifax – once it’s 30 days past due.
Unfortunately, one late payment could tank your credit score, and it’ll remain in your payment history for up to seven years. The good news is your credit score will start to rebound over time if you responsibly manage your other debt obligations. That said, it’s a must that you bring the small business loan current and continue to make payments to avoid further damage to your credit profile, collection activity or, even worse, a lawsuit brought against you by the lender.
What to Look Out for with Personal Guarantees on Business Loans
Before signing on the dotted line of a business loan agreement, be sure to look out for the following with regard to personal guarantees.
“Bad Boy” Clauses
The “bad boy” clause protects lenders against fraudulent borrowers. It allows a limited guarantee to be converted into an unlimited guarantee so the lender can collect what they’re owed without sustaining significant financial losses.
Vague Language
The contract should specify the terms of the personal guarantee. If not, request clarification from the lender and refrain from signing until you fully understand what’s being stated or the verbiage is modified.
“Continuing Guarantees”
Continuing guarantees cover the current business loan and any subsequent financing products you get from the lender. Consult with your attorney to determine if you should sign or decline the offer.
“Joint” and “Several” Language
This is common with limited guarantees that come with business loans taken out by several partners. Before signing a personal guarantee, be sure that you understand the percentage of liability you’re assuming to avoid any surprises later on down the line in the unfortunate event that the company faces cash flow issues and defaults.
Should You Get a Business Loan with a Personal Guarantee?
It depends on the financial health of your business and the likelihood that you’ll default on your payments. So here are some questions to ponder before making a decision:
- Is your company financially stable? Have you taken a moment to run the numbers to determine how much your company can afford to borrow based on the borrowing costs and monthly payments? Are the monthly payments low enough to not place too much financial strain on your company’s financial health?
- Do you have the ability to pull from your personal savings to cover the monthly loan payments if your business fails and files for bankruptcy or faces cash flow issues? Ideally, you want your company to generate enough earnings to cover the monthly payments on a business loan. But you also want to confirm that your personal assets are sufficient enough to cover the payments should your company encounter cash flow issues, as you’ll be required to make the monthly loan payments or risk damaging your credit health.
- Do you understand the fine print regarding the personal guarantee? Are the details of the personal guarantee, including the liability you assume and what it means for your personal finances, clear to you?
- Are you fully aware of the risks that come with signing a business loan with a personal guarantee? Do you understand the seriousness of defaulting on a business loan with a personal guarantee? Did you know your credit rating, collateral and personal assets, including checking and savings balances, could be at risk (in some instances) if your business defaults on the loan payments and you’re unable to pay from your personal funds?
- Are you prepared to suffer the consequences of non-payment? There’s no surefire way to guarantee that your company will be successful, particularly if you’re just getting started considering the failure rate of small businesses in the early stages. Although business owners don’t like to anticipate these rough patches, there’s a chance they could surface and take a toll on the financial health of both your personal finances and the company’s finances. And if you’re unprepared to pick up the slack and make payments, you should be ok with dealing with the consequences that come with defaulting on a small business loan with a personal guarantee.
This list is not comprehensive but gives you an idea of the level of risk you’re assuming by signing a business loan with a personal guarantee.
Also, reach out to your accountant and attorney, if possible, to discuss the business loan agreement and ensure the personal guarantee disclosures are sound.
