What is a Personal Guarantee?

Explanation

In simple words, the guarantee means providing security.

  • When talking about a personal guarantee, it refers to the promise made by a person to honor the agreement and accept and make the payment of the liability and obligations as agreed in the agreement. The guarantor’s assets may or may not be attached; the same may be decided when getting into the arrangement.The personal guarantor makes this legal promise to the lender to support the borrower to help him get the loan or debt.In the event of default by the borrower, the lender may claim the personal guarantor to make good the default.

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Purpose of Personal Guarantee

  • The purpose is to ensure that the promises made in an agreement are performed.When such a guarantee is given, the person is personally responsible (i.e., in his capacity, which means attaching his assets) to fulfill the promise and compensate the lender if the borrower makes any default on his part of the promise.

Features

  • The lender should have tried all ways to recover the debt from the borrower first. Only then can he go to a personal guarantor.It’s a conditional promise, i.e., only if a borrower defaults, the lender may resort to recovering the dues from you.There should be a balance of debt/liability which is pending repayment.

Types

#1 – Limited Guarantee

  • In an agreement with multiple owners/partners, each of them shall have a fixed percentage of holding in the business.Accordingly, each guarantor shall be obligated to honor only to the extent of such a fixed amount of liability in case the business defaults.Going deeper, a limited guarantee can be either (i) several guarantees or (ii) joint and several guarantees.Several guarantees mean that your obligation to repay the balance debt is restricted strictly to the extent mentioned in the loan agreement.A joint and several guarantees mean several guarantees (as explained above) but extended with the responsibility of fully repaying balance debt if an owner/partner does not pay up their required portion.

#2 – Unlimited Guarantee

As the title suggests, offering an unlimited personal guarantee means that the guarantor is fully responsible for making the repayment dues in case of default by the borrower, whether or not you owe a guarantee of 100% repayment.

Why do Lenders need a Personal Guarantee?

  • The main reason lenders ask for a personal guarantee is to ensure security to the amount being lent. Further, it also gives them an added assurance and comfort that the borrower shall pay the loan amount duly on time.It helps them make sure that the borrowers are committed to making the repayments and shall not take any undue advantage or utilize the loan amount in any unwanted and unnecessary ways.

Reasons

  • For the borrower, a personal guarantee may help businesses fetch loans that may not have been possible earlier or get a bigger loan amount sanctioned.This will assure the lender that the money shall be repaid in case of defaults and that his money is secured.

Risks

  • The biggest risk entails that once the same gets invoked, you are liable to fulfill the arrangement as there is a legal binding attached to it and make good the debt.It may be possible that you may have to use all your savings, kept aside for children, retirement, emergencies, etc., and pay the dues. You may have to use your assets to pay up in case of high loan amounts.In high-risk scenarios, bankruptcy is also possible.So before signing for any personal guarantee, it’s’ always safe to read and understand every term and liability.

Advantages

  • The credit history and credit rating of the guarantor are considered along with the borrowers’ credit history and rating.Improved/better credit backing/availability for a loan.Improves chances of fetching a loan for a small business which may not have been otherwise possible.Gives an assurance to the lender that the loan shall be repaid.

Disadvantages

  • If the business does not grow or fails to earn the required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more, and loan default, the personal guarantor may be required to help make the loan payments.Personal assets may get attached and utilized for repayment purposes.Credit rating may be affected when a personal guarantee is invoked and required to pay.

Conclusion

  • To summarize, a personal guarantee refers to that enforceable part of an agreement having a legal binding that if the borrower does not fulfill his obligations towards liabilities/dues, this guarantee shall be invoked, and the personal guarantor is liable to honor the agreement.It may be either limited or unlimited. Further, personal assets may also be attached for repayment, if required.

This has been a guide to personal guarantee & its definition. Here we discuss the purpose of such guarantees, features, and types along with reasons, risks, advantages, and disadvantages. You can learn more about from the following articles –

  • Financial GuaranteeBank GuaranteeLetter of GuaranteeRecourse DebtBoard of Advisors