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As your business grows and makes purchases that require financing, you will often come across terms like business credit score and personal guarantee. As you may already know, businesses have credit scores that allow financial institutions to deem how trustworthy they’ll be as a borrower. Many small businesses and startups require business loans to fund their ventures, but getting approval can be tricky. Only around 27.9% of small business loan requests at big banks get approval. Depending on the size and age of the business, lenders may not feel comfortable loaning money without substantial business history or proof of financial stability. The is where the personal guarantee comes in. Read on to learn more about what a personal guarantor is, the implications of a loan guarantee, and how guaranteed loans will affect your financial position.
What is a Personal Guarantee
A personal guarantee is a written agreement to accept responsibility for the debt of a loan or lease. If a business does not have its own credit rating yet, a personal guarantee can make or break approval. Likewise, with a less than desirable credit score, a personal guarantee can make lenders feel more confident in the business. This is because they know the owner will repay the loan if the business cannot.
With a loans guarantee, the individual who cosigns is known as a personal guarantor. The guarantor pledges to pay off any outstanding debts with their personal assets, such as:
- Real estate
- Other assets (such as a car)
A personal guarantee is a loans guarantee
In many ways, the personal guarantee acts as a safety net. If a borrower defaults, this guarantee authorizes a lender to collect any assets necessary to cover the remaining cost of the loan. It’s a standard part of a loan agreement and describes the methods a lender can use to recover their investment.
Why Lenders Require Personal Guarantees
All loans must go through underwriting to evaluate the borrower and analyze their likelihood of being able to pay back the loan. Lenders often look to a business’s credit score. However, a young business likely won’t have a favorable credit history. This increases business risk, which in turn leads to higher interest rates for the borrower. Otherwise, lenders may request a form of security (many times they require both).
The “security” is what we call the personal guarantee. Another common approach is for a financial institution to have you provide collateral through your business assets. Without collateral or a personal guarantee, lending would simply be too risky for newer businesses. Because of this, business owners would never be able to obtain loans.
The Risks Associated with Guaranteed Loans
Guaranteed loans always carry a risk. It is important to understand what these risks are and how they could affect you and your business. If the worst were to happen, it’s important to know what the possible outcomes are.
Using your personal credit score to help get a business loan approval will negatively affect your business score if you miss payments or default. Guaranteed loans can harm your credit score and take years to improve depending on the severity of the default.
If the assets you put up in case of default do not cover the outstanding loan amount, the lender can take legal action. Anytime when you default on a loan, that will remain in your credit history for several years and result in a higher level of difficulty when trying to find a job, insurance, etc.
In the event of a default, lenders will go after anyone else who is on the agreement as a personal guarantor. Some financial institutions require a spouse to sign the agreement as well. This means their assets are liable to pay off the debt if yours don’t cover it.
Additionally, if you are in a joint partnership agreement, all partners will be responsible for repaying. If your business partners are not able to repay, you will be held liable for 100% of the repayment.
Having another personal guarantor opens them to financial risk if you or your business partners not make your payments.
3 Things to Look Out for Before Signing
Signing any agreement requires one to make sure to take the time to read the fine print and request any changes BEFORE a signature is provided. Make sure to communicate any items that make you feel uncomfortable or need clarification before signing a personal guarantee.
1. Vague language
Be wary that the language can be quite vague, on purpose! This allows a lender to have a lot of freedom in interpreting what they can require of you, should you or your partner default. Furthermore, it’s worthwhile to hire a legal professional, who will help you decipher all components of the agreement.
2. Pushy provider/lender
If you find that a lender is pushing you to act quickly, this is a tell-tale sign that this may not be the best provider for you. Hence, you will need time to read all provisions, request changes, and negotiate terms.
3. Added loan default clauses
Is there any way your lender could ever change the limits of your guarantee? Question this and negotiate terms. You do not want to allow the bank/provider to have unlimited access to anything and all that you or your loved ones own.
Is a Personal Guarantee Right for You?
As you can see, no loan is without risk. When you sign, you give the lender the authority to collect from your personal assets if you default. Therefore, take the time to read all terms and understand exactly what you are signing. You may even seek legal counsel to ensure you protect yourself from any unnecessary risk.
If you’re uncomfortable with the level of risk, there are other options you may want to consider, including:
- Collateral: Collateral loans are a type of secure loan. Essentially, you will specify an asset the lender can seize for repayment if necessary. Generally, it’s less risky to identify the collateral ahead of time rather than give a provider the power to use any assets to obtain the money they are owed. A few types of items that can be used as collateral are unpaid invoices, property, inventory, and even cash to name a few.
- Blanket Business Lien: This type of lien is just like a personal guarantee. However, it will use your business assets instead of personal ones. This way, if the business defaults on payment, the lender can go only after the business assets and even bankrupt it if necessary. Please note most blanket liens will include a clause that still requires a personal guarantee to repay the debt.
So, What Are The Next Steps?
Make sure to analyze your business’s financial position and your personal finances before considering signing a guarantee. It is important to look at your business’s financial planning and budget before securing any type of loan. Make sure you can confidently repay any loan you choose to take out. A personal guarantee will increase your chances of securing a loan if you’re comfortable with it. Do your homework and choose the best solution for your needs.