Updated July 10, 2023
What is a Personal Guarantee?
The term “personal guarantee” refers to the legal promise of an individual to repay the credit issued to a business or another individual in case the borrower fails to repay the same.
If the business or individual defaults on a loan, the individual offering the personal guarantee must assume responsibility for repaying the outstanding balance. In this way, it provides an extra layer of protection for the credit issuer who wants to minimize the loss on default.
Some of the key takeaways of the article are:
- It is a legal promise by an individual to repay the credit issued to a business or another individual.
- It helps small and new businesses or those with limited credit history get credit for business purposes.
- By invoking personal guarantees, the lenders can mitigate the risk of default since they have a legal claim to the guarantors’ assets.
- Invoking the personal guarantee due to default by the original debtor may affect the credit score of the guarantor.
How Does it Work?
Lenders usually ask the business owners or executives to provide personal guarantees to access credit, especially if the borrowing companies are too new or have a weak credit history. Essentially, personal guarantees are provided by new and small businesses.
Typically, a business principal offering a personal guarantee provides their credit history and profile as part of the primary evaluation of the credit application for a loan. By extending the personal guarantee, the principal pledges their assets and agrees to repay the debt personally if the original borrower defaults. As such, the credit application, in this case, includes the guarantor’s social security number (SSN) and the borrower’s employer identification number (EIN), and financial statements.
Below are some examples of personal guarantees.
David provided a personal guarantee for a loan availed of by Ben. Ben could not make the payments per schedule one year later, so the personal guarantee clause was invoked. So, at that time, David became the eventual debtor of the loan and had to repay the outstanding balance. This way, the lender made David cover Ben’s liabilities and safeguarded their money.
Another example is the corporate credit cards issued to the employees of an organization. Although the company bears all the expenses covered by these cards, the individual employees are responsible for the debt taken by the organization. Here, the individual employees or cardholders take the role of personal guarantor.
Impact of Personal Guarantee
When an individual provides a personal guarantee, the lender can pursue them personally if the original borrower can’t repay the business loan. This can translate into different things based on the terms and conditions of the loan agreement. For example, as part of the guarantee, the individual might have to give the lender permission to take possession of their assets, including investments, valuable items, homes, or other real estate properties. So, suppose the original borrower cannot make timely periodic payments. In that case, offering a personal guarantee will negatively impact the individual’s credit rating and overall credit profile.
Uses of Personal Guarantee
In the underwriting process, the lenders assess the borrowers to determine their ability to repay loans. In the case of consumer loans, lenders can draw assistance from credit scores and other similar sources of information while assessing prospective borrowers’ credit.
In the case of businesses, especially new companies or those with limited credit history, the lenders often don’t have any specific sources of information for business-related credit history. Therefore, it becomes difficult for lenders to decide due to inadequate information. To overcome this shortcoming, the lenders request security through it. Small businesses sometimes can’t even get loans without a personal guarantee.
Benefits of Personal Guarantee
Some of the major benefits are as follows:
- The credit profile of the guarantor is considered while assessing the application of the borrower profile. This boosts the borrower’s credibility in the underwriting process.
- It provides the lenders an extra layer of protection or assurance, which means improved recovery in case of default.
- Small businesses can avail of loans they won’t get without a personal guarantee.
Disadvantages of Personal Guarantee
Some of the major disadvantages are as follows:
- If a business fails to generate enough profit or return to pay off the loan, then the personal guarantor will become the eventual debtor for the loan.
- The guarantor’s assets will get attached and utilized to repay the defaulted loan.
- The guarantor’s credit score may get affected if the personal guarantee is invoked due to default by the original debtor.
So, a guarantor must read the terms and conditions of the loan agreement before getting into one. Also, the guarantor should objectively consider the business’s financial position and understand its repayment ability. Ideally, the original borrower will repay all of its debts on time and in total, which means that the personal guarantor doesn’t need to worry about it.
This is a guide to Personal Guarantee. We also discuss the definition, working, examples, impact, uses, benefits, and disadvantages. You may also have a look at the following articles to learn more –