While personal guarantees are most commonly seen when signing up for a small business loan or business credit card, they're also used in commercial real estate. If you're thinking of taking out a commercial loan, you may be asked to sign this type of loan agreement. We've created a guide to personal guarantees. Keep reading to learn more about what a personal guarantee is, how it works, and what you need to know before signing on the dotted line.
What is a personal guarantee in real estate?
In business finance, a personal loan guarantee is a type of loan agreement made by a small business owner or another type of business partner. In this arrangement, the borrower agrees to take personal liability for a business loan in the event the business is unable to repay its debt. Notably, loans with this type of guarantee are often unsecured loans, which means they aren't backed by any other collateral owned by the business.
While people don't usually go into a lending arrangement intending to default on their business debt, unfortunately, opening up a new business venture is tricky. It's always uncertain whether the business will succeed, which presents a risk for the lender. As a result, lenders ask for a legally binding personal guarantee to safeguard their chances of being repaid.
What are the different types of personal guarantees?
When discussing the particulars of business financing, there are two types of personal guarantees: unlimited personal guarantees and limited personal guarantees. To help you better differentiate between the two agreements, we've detailed each type below.
Unlimited personal guarantee
As the name suggests, an unlimited personal guarantee is the broadest type of agreement. In this case, as the guarantor, you're agreeing to take on total liability for the loan amount, as well as any legal fees that may result if you default. Here, if the corporate entity can't repay its debt, this type of loan guarantee allows the debtor to go after your personal assets, such as your home, car, and retirement savings, until they have been repaid in full, including interest.
Unsurprisingly, an unlimited personal guarantee is weighted very heavily in favor of the lender. As the borrower, you and your assets are afforded very little protection, so be very careful when signing one of these agreements.
Limited personal guarantee
On the other hand, a limited personal guarantee offers the borrower more protection. In this type of business financing arrangement, you take on a limited liability. Here, the loan agreement will specify a dollar amount you agree to repay with your personal assets if your business defaults.
Notably, this type of arrangement is often used when there are multiple business partners who have a financial stake in the company. Rather than having one person take responsibility for the personal loan guarantee, the business partners will share the liability. For example, when taking out an SBA loan, anyone who has at least a 20% stake in the company is required to be part of any personal guarantee process.
What are the pros and cons of signing a personal guarantee?
Now that you know more about personal guarantees and the way they function, let's go over the pros and cons of signing one of these agreements. We've laid out some of the advantages and disadvantages to this type of business financing below.
When you sign a personal guarantee, you effectively ensure you don't have to put up collateral for the loan or take on any form of a business lien. If you don't want to put your corporate assets at risk, this can be an effective way to protect those assets while still ensuring you get the business loan you need. Additionally, if you're confident you can repay the debt, either through your business or personal assets, signing a personal guarantee may not be a big deal.
That said, signing a personal guarantee should not be taken lightly. Often, the language in these agreements is intentionally vague in order to make it difficult to limit the amount of liability that you'll face as the borrower. In fact, in some cases, there's even language that allows the creditor to convert a limited personal guarantee into an unlimited one. If that happens, the creditor would be able to come after all of your assets.
Unfortunately, a personal guarantor can face bankruptcy as a result of signing one of these agreements. If that happens, there will be a substantial negative impact on your credit score, making it harder for you to qualify for any type of future financing on a personal level.
Considerations before investing in a personal guaranty
Finally, we would be remiss if we didn't talk about the considerations that come along with offering a personal guarantee as a lender or investor. As with any type of business arrangement, this type of lending agreement should not be entered into without doing your due diligence. Here are a few things to consider before you invest.
Check the borrower's personal financials
Obviously, before you lend money for any sort of business loan or business line of credit, you'll want to check out both the business's financials and the guarantor's personal financials. In particular, you should make sure the business has sufficient cash flow to cover its payments and a net worth large enough to repay the debt.
However, you should also take a look at the borrower's personal credit history and net worth. If the business does end up in default, you want to make sure the borrower can repay the debt.
Hire a lawyer to draw up the agreement
It's a good idea to have the legally binding agreement drawn up by a professional like a real estate attorney. While doing so may come with legal fees, they are worth paying if you can rest assured you'll receive a return on your investment.
Sell the debt to a factoring company
If the business does end up defaulting on its obligations, you may want to consider selling the debt to a factoring company, the corporate version of a debt collector. They buy outstanding invoices from businesses with slow-paying customers to help the businesses boost their cash flow. However, this service is not free. Factoring companies typically buy debt at a discount.
The bottom line
Whether you're looking to take out a commercial loan, it's not uncommon to have to sign a personal guarantee. However, entering this type of arrangement needs to be taken seriously, because defaulting can have tremendous financial repercussions.
If you're considering signing one of these loan agreements, make sure to read it carefully so you understand your rights and responsibilities. As always, if you have any questions, reach out to a financial professional before signing on the dotted line.