A personal guarantee is a promise to the lender that if the business is not able to repay the loan principal and interest, the borrower will pay it with his own money. The need for a personal guarantee arises from the legal structure of a business. The whole reason corporations, partnerships, or limited liability corporations are formed is to shield the owners from the obligations of the business.
If a business is late in payments or is unable to comply with any of the requirements of the loan, the loan can be declared to be “in default.” There is a time limit on how long the business has to “cure” the default, but after that time, the lender can “call the loan.” As soon as a loan is called, a series of legal actions are initiated against the borrower AND the personal guarantors (those who signed the guarantee). It is not unusual for a bank to require both a husband and wife to sign guarantees. That way there can be no hanky-panky in moving personal assets around to avoid liabilities.
As part of most loan applications, borrowers have to submit a personal financial statement listing all assets and liabilities. This helps the lender to satisfy loan shortfalls if the business was not successful. It also gives them a road map as to where to go to seize them if that becomes necessary. This personal financial statement is commonly updated annually as long as the loan is outstanding.
Banks make money by earning interest and fees on performing loans. They don’t make money by seizing assets and selling them. In fact, when they liquidate assets to satisfy loans that have been called, they are not allowed to keep any excess money they recover. They must return any surplus to the borrower. The last thing a bank wants is to have to call a loan. When that happens, they have to attach liens to the property that is collateral, appraise it, market it and liquidate it. The result is usually only 60% of the fair market value of the collateral.
Lenders are usually not required to go after business assets first before turning to the owners’ personal assets. They can go after whichever is easier to take control of and sell.
When I owned a manufacturing business, the company had a sizeable bank loan. One day I asked my loan officer if the bank realized that there was no way they could ever recover the full amount of the loan principal from my personal net worth. He let me in on an insider’s secret. “If the business hits a bump-in-the-road, THE BANK wants to make sure we keep your “ass in your seat” and figure a way how to solve the problem for us and get our money back!”
do not require personal guarantees by the borrower. The most popular personal assets used for this purpose are jewelry, watches, and fine art. The liquidation value of the asset being pledged fully collateralizes the debt. If the loan can’t be repaid, the asset is liquidated to fully satisfy the loan obligation. There is no further action that can be taken by the borrower.
An additional is that they are not reported to the credit reporting agencies. There is no record of the loan or any delinquency listed in the borrower’s credit rating. This is the opposite of a defaulted bank loan, which can harm a borrower’s credit rating for years