If you’re in the process of applying for a bank loan for your small business, you may have been asked by your lender to make a personal guarantee for your loan. While making a personal guarantee can help you qualify for the loan or even get a better interest rate, there are a multitude of risks involved.
Just what is a personal guarantee, and how do you know whether it’s the right choice for your business financing needs?
Let’s break down what you need to know before making a personal guarantee for your small business loan.
What is a Personal Guarantee?
If you’re applying for a loan for a relatively new business with little business credit history, lenders may require you to tie your personal finances to the business in order to qualify for a business loan.
A personal guarantee is an agreement with your lender that puts your personal assets on the line, essentially making you the loan’s co-signer. If your business were to fail, you would be personally responsible for repaying the loan. This means creditors can claim your personal assets (home, investment accounts, etc.) as repayment.
Personal Guarantee vs. Collateral
Personal guarantees are frequently confused with another common small business loan requirement: collateral. But whereas putting up collateral on a loan requires you to stake one or a few particular assets—such as a house or other property—to guarantee your loan, a personal guarantee leverages any and all financial assets that you have now or may have in the future to secure the loan.
Lenders more often request a personal guarantee instead of collateral if the loan amount is particularly large or if the borrower doesn’t own property of comparable value to the loan principal.
Is a Personal Guarantee Necessary to Obtain a Small Business Loan?
This usually depends on how long you have been in business, and whether you have established business-specific credit.
New small business ventures are inherently risky, so lenders typically won’t feel confident backing these ventures without some sort of assurance.
If you own a newer business and haven’t had a chance to build up business credit, the majority of bank lenders will require that you either sign a personal guarantee or offer some particular asset as collateral for your first business loan. It’s often more of a psychological measure, as they know that you will make repayments in order to hold onto personal assets.
The good news is that most business owners only have to do this for their first business loan. Once your venture builds positive business credit and assets for collateral you won’t have to personally guarantee loans anymore.
Personal Guarantees and Business Partners
If your small business is established as a partnership, or multiple individuals have an equity stake, the lender may require all or more partners to make a personal guarantee on the loan. By the Small Business Administration’s standards, anyone with a 20 percent or greater stake in the business should be part of the guaranteeing process.
Risks of a Personal Guarantee
The major risk you run when signing a personal guarantee is that your business venture will fail and your lenders will come to collect your personal assets, such as your home, your children’s college funds, or any collateral up to the amount that was originally set as your loan, plus interest.
It’s the business financing equivalent of going “all in” at the poker table, so you’d better be sure of your hand before you make such a commitment.
While many entrepreneurs would prefer not to risk this scenario, in the eyes of your lender, a personal guarantee is a vote of absolute confidence in your business and its ability to get off the ground.
Alternatives to Making a Personal Guarantee
If betting the store is more risk than you can stomach, different types of loans may not require personal guarantees. An online alternative lender may be able to offer an unsecured or signature loan which does not require a personal guarantee or any sort of collateral. You could also consider financing your business with a business credit card or through a peer-to-peer lender.
Of course, with these alternatives, you’ll pay for the lender’s increased risk through high interest rates and more stringent terms. But some business owners may consider this alternative worth the cost to protect their personal financial security.
While it may be too much of a personal risk for some, remember that a personal guarantee is a way of showing you have some ‘skin in the game’; that you truly believe in the efficacy of your business model and its ability to succeed.
If you’re confident in your business model and certain that your business financing will be put to good use, making a personal guarantee can be seen as just one more step in the business funding process.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.