A couple I’ll call Jake and Marcia purchased a coffee shop. The business was really Marcia’s dream, not his, but she was persistent and he reluctantly agreed to try to help out. Things went badly from the start and within less than 18 months they were forced to shut it down. But that wasn’t the worst of it. Because they had obtained a loan that required a personal guarantee to purchase the business, they were facing the possibility of losing the home where they raised their children. Needless to say, their relationship was also quickly going south, with Jake accusing his wife of putting their entire future at risk.
What is a personal guarantee and what does it mean? And what about your personal credit? Does it affect that, too? As a corporate attorney working with small-business owners all over the world, I’ve heard a lot of questions, misconceptions — and some horror stories, like Jake and Marcia’s — about how personal guarantees work.
Basically, a personal guarantee allows a lender to try to collect from what you own personally if you default on a loan and your business is unable to repay it. It allows a lender to reach beyond the income and assets of the business to collect if necessary.
Should You or Shouldn’t You?
The newer your business, the more likely it is you will be required to provide a personal guarantee. It provides additional protection for the lender, and if your business doesn’t have a strong track record, it’s no surprise the lender will insist on one.
Entrepreneurs are often optimistic and willing to do whatever it takes to get the funding they need. But if you are going to sign a PG, make sure you fully understand the risks. If you have a spouse or partner, they need to be on board as well. (Sometimes they may be required to sign the loan documents, too, especially in community property states or where equity in jointly held property serves as collateral.)
If all goes well, and you pay the loan back, then there’s no problem. But if you run into financial difficulties, you need to understand that the lender may try to get repaid through your personal bank accounts or other assets (to the extent allowed by law).
Keep in mind that what types of property are available to creditors who get a judgment depends on state law. A few states prohibit wage garnishment for most types of debts, and others have strong homestead laws that may protect equity in a home (Texas and Florida are two examples).
Is Your Credit at Risk?
Signing a personal guarantee doesn’t automatically impact your personal credit. With the exception of some business credit cards, most loans made to a business are not typically reported on the owner’s personal credit reports — unless he or she doesn’t pay the loan back and it goes to collections. A personal guarantee doesn’t usually change that. But if you sign a personal guarantee and you don’t repay the loan, it’s likely it will wind up on your credit as a collection account, or even a judgment, and will hurt your credit scores.
This is one of many good reasons to regularly check your credit reports and credit scores. You can get a free annual credit report from each of the major credit reporting agencies once a year through AnnualCreditReport.com. You can also get your credit scores for free from many sources, including Credit.com, to watch for important changes.
One way to avoid personal guarantees is to build strong business credit ratings, which I explain in my new book, Finance Your Own Business, and to demonstrate to the lender that your business can support the loan through sales and revenue. These guarantees may be negotiable. If you’re not there yet, tread carefully and borrow as little as possible. The less you borrow, the less is at risk if things don’t work out.
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This article originally appeared on Credit.com.
This article by Garrett Sutton was distributed by the Personal Finance Syndication Network.
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