What Is A Personal Guarantee And Why You Should Avoid Them

Seeking money for a new business venture or to help an existing one grow typically starts with applying for a business loan.

Depending on what type of credit the business may have established, most lenders will want a personal guarantee. If you are the business owner, this means co-signing for a business loan.

Before you sign for a personal guarantee, you should fully understand what you are getting into.

In this article, we'll go over what a personal guarantee is and why you should avoid them.

What Is A Personal Guarantee?

Most small businesses will find that they must personally guarantee any business loan they apply for.

Lenders view small business loans as risky and want some guarantee that the borrower can cover any potential loss.

Because lenders view businesses are risky, they aren't counting on future revenues as a guarantee of payment. Instead, they turn to the business owner's personal assets.

A personal guarantee doesn't mean the business owner will have to put their house up as collateral, although that can happen. The type of asset needed to secure the loan will depend on the lender. 

One reason to avoid a personal guarantee is that your assets can be taken by the bank to pay off the loan in the event that the business fails.

If you guaranteed the loan with your residence, this means the bank can take your residence. For a new, unproven business venture, it may not be worth the risk.

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For a business with multiple owners who have at least 20% ownership, each will be expected to personally guarantee the loan up to their percentage ownership.

Depending on how well the business owners get along and their ability to successfully run the business, a multi-owner loan can be very risky. It only takes one owner to default on his share of the loan.

This forces the other owners to cover the absent owner's share of the payment or risk negatively impacting their personal credit while putting their personal assets in jeopardy at the same time.

One problem with an owner not living up to his side of the deal is that the other owners may not be prepared or have the financial means to cover the shortfall.

While you may be making every payment of your portion of the loan on time, this unfavorable scenario will put you in the same boat as the other owners who are unable to meet their obligations.

Potential Impact On Your Credit Profile

When you personally guarantee a loan, your credit report will be pulled and reviewed by the lender.

As with most loans, your credit score will weigh heavily as a deciding factor, along with any outstanding loans.

If you are approved for the loan, beware that defaulting on a business loan that you have personally guarantee will negatively impact your personal credit.

Business Credit Cards And Your Personal Credit

Applying for a business credit card is a type of loan, but more specifically, it's a line of credit. For a new business or one with no credit or assets, you will be required to personally guarantee the business credit card.

This process is just like applying for and owning a personal credit card.

Your credit report will take a hit (inquiry) during the application process. If the business fails to pay its minimum payments at any time, your personal credit report will take another hit.

Additionally, late fees will be added to the credit card account, and the credit card terms may even change. For example, the credit card company may decide to decrease the account's grace period.

Depending on the amount of debt the company has incurred on the credit card, this can start a vicious cycle where payments are coming due faster than you can make them, dragging your personal credit down even further.

Types Of Lenders

There are a number of lenders available for business loans. Some will be more willing to forego a personal guarantee than others.

Lenders such as the SBA, OnDeck, and a traditional bank will likely require a personal guarantee.

However, seeking out a local community bank may put the odds in your favor. Although, keep in mind that if you are trying to acquire funds for a startup, you'll likely need a personal guarantee no matter who you go to.

 "Community banks' whole niche is to work with small business people, because it's too expensive for the big banks to work with them," Dan Short, a professor of accounting at the Neeley School of Business at Texas Christian University, told Inc. "The small bank has a tremendous incentive to make that work, but they'll need to know whether you have the right capital to get started."

"If you're going to start a business, you've got to be willing to lose some money," Short says. "But don't lose your entire future, your house and your children's college education by pledging too much."

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LLC Protection And Personal Guarantees

Moving from a sole proprietorship to an LLC provides some additional legal protections for your personal assets.

However, when you sign for a personal guarantee, you are voiding the LLC's protections. A personal guarantee tells the bank that you are personally responsible for problems that arise from the loan.

A personal guarantee allows the bank to go after your personal assets and has nothing to do with the LLC's legal protections.

Loan Alternatives

Of course, not getting a loan in the first place can help avoid personal guarantees. The following options will be limited to a select, few but for those few, you should certainly take advantage of the opportunity.

In this case, we're referring to family and friends. Borrowing from family and friends doesn't require the strict loan application process as is required by traditional lenders and you'll have a better chance of actually getting the loan.

Keep in mind that Just because you know your family doesn't mean you should take advantage of their generosity.

Draw up an agreement and formalize your loan. Include a market interest rate as well. Your family or friends will at least have more confidence in your how serious you are about making the business a success.

Summary

What are the negatives of a personal guarantee?

One reason to avoid a personal guarantee is that your assets can be taken by the bank to pay off the loan in the event that the business fails. If you guaranteed the loan with your residence, this means the bank can take your residence. For a new, unproven business venture, it may not be worth the risk.