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How a personal guarantee on a business loan works
What you should know before you personally back a business loan.
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If you’ve spent some time searching for a business loan, chances are you’ve come across more than one that asks for a personal guarantee from the owner or owners. It’s a common feature of small business financing, especially if your business just barely makes a lender’s requirements for revenue and time in business. We break down what it means, how it can help and when you might want to consider other options that don’t put your family’s finances on the line.
What is a personal guarantee?
When you sign a personal guarantee on a business loan, it means that you’re on the hook for paying off all or part of your business’s debts if your business can’t. Personal guarantees are unsecured, meaning that they aren’t tied to a specific personal asset like your home or your car — you’re just responsible for paying up by whatever means. Many small business lenders require a personal guarantee because small businesses can be risky to lend to.
How risky? Around 20% of small businesses with employees fail in their first year, while only about half make it past the fifth, according to a Bureau of Labor Statistics Study. Businesses in certain industries like construction and transportation are even more likely to fail in their first year. A personal guarantee reassures the bank that it’s going to get its funds whether or not your business survives.
Types of personal guarantees
There are a few of types of personal guarantees out there. An unlimited personal guarantee means that you’ll cover the total loan cost if your business can’t pay off its debt, along with any associated legal fees. This is the least risky option for the lender and the most risky one for you. If you’re unable to pay off the loan with the money you have, your lender might be able to get a judgment to take any personal assets you have — like your car, home or permanent life insurance policy — to cover the remaining cost of the loan.
A limited personal guarantee is more forgiving. Here, your lender sets a cap to how much you’d owe in the event of a business failure. With a limited personal guarantee, typically any business owner with at least 20% of ownership is required to throw their hat in the ring.
A limited personal guarantee might come in the form of a several guarantee, where business owners are each on the hook for a fixed percentage of the loan amount, usually the same as your percentage of ownership. Or, you might come across a joint and several guarantee, where each owner could potentially be responsible for paying off the full amount of the loan. Worst case scenario here: Your business flops and your partner skips town, leaving you to cover the full cost of the loan on your own.
Must read: Know what you're signing
Some business lenders ask for a personal guarantee somewhere between a limited and unlimited personal guarantee. For example, there might be a clause in your contract that allows your limited guarantee to become unlimited in certain situations.
Don’t speak legalese? This might be a good time to seek out some professional advice. Personal guarantees can be a huge risk to you and your family. Some contracts are written in purposefully vague language that could potentially help your lender take advantage of legal loopholes.
Compare business loans that use personal guarantees
Pros and cons of a loan with a personal guarantee
Pros
- Increases chances of approval. A personal guarantee takes some of the risk off your lender’s shoulders, making them more willing to work with your business.
- Can help you get competitive rates. The most competitive rates on a business loan generally go to the lowest-risk clients.
- Not tied to specific collateral. Personal guarantees offer more flexibility than a secured loan since you don’t have to put any specific assets on the line.
Cons
- It’s a personal risk. Losing your business is already a personal financial hit. A personal guarantee could require you to pay off a loan at the worst possible time.
- Can be hard to get out of. This can be an issue if you sell your business in the future — you’ll still be on the hook if that business fails if you don’t change your contract.
- Your personal finances count more. Lenders often pay closer attention to business owners’s personal assets and creditworthiness when a personal guarantee is on the table, meaning that you could have trouble getting approved if you or your partner have poor credit.
Do all business loans require a personal guarantee?
No, it’s possible to find a business loan without a personal guarantee. Personal guarantees tend to come in more traditional forms of business financing: unsecured term loans and lines of credit. And most business loans that require collateral don’t typically ask for a guarantee as well. Some equipment and vehicle leases come with a personal guarantee, however.
What if I don’t have a lot of personal assets?
Since a personal guarantee doesn’t require any fixed assets — like your apartment or family heirlooms — you don’t necessarily need to have any to personally guarantee a loan. However, you typically need to have some some sort of funds to show you’ll be able to pay off the loan. You’ll also need to meet certain credit score criteria to get approved for a personal guarantee. In some cases, you might be required to submit a list of all your assets and liabilities during the application process — even if it isn’t much.
Alternatives that don’t involve a personal guarantee
There’s no way around it: Personal guarantees are a huge risk that can affect you and your family. Here are some other options you might want to consider instead of taking on that responsibility.
Secured business loan
Instead of putting your personal property on the line, consider using your business’s assets for a secured loan instead. If your business can’t pay off the loan, your lender will come in and take the collateral. There’s no risk of suddenly becoming homeless or losing your kid’s college fund. Many property, equipment and business vehicle loans are secured with the property, equipment or vehicle your business buys.
Merchant cash advance
This type of financing for retail and e-commerce businesses gives your business an advance on its future sales. While it isn’t backed by collateral necessarily, you typically pledge to pay a percentage of your business’s revenue instead of making repayments in fixed installments. Due to the more flexible repayment structure, most merchant cash advances don’t require a personal guarantee.
Invoice factoring
Invoice factoring is when your business sells its unpaid invoices at a discount to a factoring company. Your clients then pay back the company, rather than your business.
True, invoice factoring often requires a personal guarantee. But it’s rarely used because you typically won’t be able to qualify for invoice factoring if your clients don’t have a history of making payments on time. And even if it does come into play, you typically won’t be on the hook for the whole amount unless all of your clients don’t pay up on time.
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Bottom line
Personal guarantees might be standard for many business loans. But they can also be risky, especially for a new business. Make sure you understand your personal guarantee contract and hire help if you can’t make heads or tails of it.
If you don’t have strong personal finances — or just don’t want to take on that responsibility — you might want to look into other options. A good place to start is our business loans guide, where you can learn about more types of business financing and start comparing lenders.
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