Personal guarantees are a financing tool designed to reduce the risk to a lender if a borrower defaults on a loan or line of credit. As with all things related to risk, personal guarantees don’t eliminate it. They merely shift it from one party to another. In this case, the risk shifts from the lender to the person signing the guarantee.
The crux of the agreement is that the person signing the guarantee, called the guarantor, will pay the lender an agreed-upon amount no greater than the outstanding amount of the loan or line of credit if the borrower defaults.
For various reasons, people tend not to want to be guarantors for a business loan or line of credit. Continue reading to see some of the risks involved in signing as a personal guarantor.
Increased Personal Risk
The most significant reason why someone may not want to sign a personal guarantee agreement is that it exposes them to increased risk with no personal financial benefit. Normally, when a financial instrument exposes a person to risk, it provides a benefit of some kind. For example, investing in a stock exposes you to risk but there is also an upside potential of dividends and the chance that the price of the stock and your cash flow could increase.
With a personal guaranty, though, the guarantor is exposed to additional risk for no financial benefit. While there may be personal reasons to enter into a guarantee like a personal connection to the firm or person who needs the guarantor, there is no good financial reason to do so.
Increased Personal Finance Complexity
Not only does a personal guarantee expose you to risk but it also increases the complexity of your personal assets by creating a largely invisible liability that’s easy to forget about or disregard. In other words, unlike a loan balance or line of credit that you can keep track of, a personal guarantee is a contract that is often overlooked during a net worth analysis or budgeting session.
For example, say a person has a savings account with $5,000 in it and a personal credit line owed $2,000. They sign a personal guarantee for a friend’s $10,000 loan. When they conduct an analysis of personal net worth and assets the next month, they may be tempted to say they’re worth $3,000 ($5,000-$2,000). However, they’ve forgotten about the liability of the guarantee. They need to subtract an amount equal to the probability of default multiplied by the likely amount of funding that would be demanded by the lender. This is a complicated calculation and it’s no surprise that many people don’t account for the added liability and just hang there until it comes due.
Decreased Personal Control over Finances
The increased risk of a personal guarantee brings with it a decreased amount of control over one’s personal finances. Whether or not a borrower pays back a guaranteed loan is obviously up to the borrower. The guarantor has no way to compel a borrower to pay back the loan or credit line. In other words, the guarantor’s financial health is, at least to a degree, in the hands of the borrower. Many people are understandably uncomfortable with this lack of control.
Conflict of interest
In some cases, signing a personal guarantee creates a conflict of interest. This is especially common when the guarantor has a personal or business relationship with the borrower. An example may serve to illustrate the concept.
Say a board member of a non-profit agrees to sign a personal guarantee for a non-profit credit line. The non-profit racks up $25,000 of debt and runs into financial difficulty. The lender calls the loan and demands payment and the board meets to discuss the issue.
The board decides that it is best not to pay back the loan (or at least the entirety of the loan). Perhaps the non-profit is insolvent or has other obligations that take priority. Suffice to say, the guarantor board member is in a bind. In his personal capacity, he would prefer that the organization make this line of credit a priority and pay it back immediately. In his capacity as a board member, he agrees with the decisions of his other board members.
His loyalties are split. He’s torn between his fiduciary duties as a board member and his self-interest in his own assets. It’s for reasons like this that signing a personal guarantee for a business or non-profit that you’re personally involved with may necessitate making arrangements or taking precautions against acting in a way that harms the organization. At the very least, it can complicate your role with the organization.
Should I Sign a Personal Guarantee?
No one can answer this question except for you. It depends on your circumstances, the nature of the contract, and the circumstances of the borrower and their ability to repay the loan.
That said, we can be sure that if you have the option not to sign a personal guarantee when someone is seeking financing, it is something you should seriously consider. There’s no reason to sign onto personal guarantee insurance unless it’s absolutely necessary.
Financing Solutions
Financing Solutions, a leading provider of business loans for nonprofits in the form of a 501c3/not-for-profit line of credit, does not require you to provide a personal guarantee of the line of credit they offer to non-profits. They also don’t require collateral. Instead, they control the risk by relying on their many years of experience lending to non-profits with annual revenues ranging from $200,000 to $5,000,000.
The knowledge they’ve gained allows them to rapidly assess whether you likely qualify for a non-profit line of credit. In fact, their credit line application allows you to access a quote in just a few minutes.
Alternatively, give them a call at 862.207.4118 and let them know what you’re looking for. They’d love to chat with you.
