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Choosing the right type of business financing is important to all small business owners because business debts impact a companyâs long-term financial health. Loans are a great financial tool to start or grow a business, but if they are not managed properly, they can hurt a businessâs future creditworthiness.
Some of the decisions borrowers must face during a loan application process include whether to provide collateral or a personal guarantee, how much down payment to offer, and what repayment terms will work for their budget. Many small business owners choose to provide a personal guarantee, although they may not realize the impact that guarantee will have on the future of the business. In this article, we take a close look at the advantages and disadvantages of providing a personal guarantee on an unsecured business loan.
What is an unsecured business loan?
An unsecured business loan is a type of small business financing where the approved borrower is not required to provide collateral, like commercial real estate, personal assets, or equipment. Since there is no collateral required, the approval requirements for unsecured loans typically require that the borrower have a higher personal credit score or good business credit history. In addition to approving applicants based on creditworthiness, lenders often require a personal guarantee when funding an unsecured loan.
The alternative to an unsecured business loan is a secured business loan, where the borrower has pledged an asset to the lender as a promise to repay the loan. If the borrower defaults on a secured loan, the bank, credit union, or lender can take possession of the asset as payment for the remaining debt. The reason unsecured loans require higher credit scores and offer lower loan amounts is that if a borrower defaults on an unsecured loan, there is no available asset for the lender to liquidate. However, even though there is no collateral on an unsecured loan, lenders can take the following actions if the borrower defaults:
- Commission a collection agency
- File a lawsuit against the borrower
- Input derogatory remarks on the borrowerâs credit report
- Garnish the borrowerâs wages (with a default judgment from the courts)
- Place a lien on the borrowerâs personal assets
Types of unsecured business financing
Many types of business financing, like term loans, offer both unsecured and secured loan options. However, if youâre considering unsecured business financing, check out the following types of loans:
Business term loans are a traditional source of small business financing where the borrower is approved for a maximum loan amount and then receives a lump sum payment upfront. Term loans can be unsecured or secured, but typically small business owners are only able to secure unsecured term loans that have a short repayment term. Monthly payments of interest and principal are then made by the borrower until the total loan balance and financing costs are repaid according to the repayment terms.
Unsecured short-term loans work well for borrowers that need to make a large purchase or supplement working capital. Advantages of term loans include predictable repayment terms and low-interest rates. The interest on term loans can be fixed, where it remains the same over the life of the loan, or have a variable interest rate where it is determined by the market rate. Another benefit of term loans is that most borrowers can pay the balance of the debt off early without prepayment penalties.
Merchant cash advances
A merchant cash advance (MCA) is a way for small businesses that collect credit card or debit card revenues to receive a cash advance using their future sales as collateral. The borrower repays the advance, or loan, with weekly or monthly, payments based on a predetermined percentage of sales. MCAs are a great financial tool for borrowers that have bad credit or no business credit history or those that do not otherwise qualify for unsecured financing.
Business lines of credit
Unsecured lines of credit provide revolving credit to small business owners. Business lines of credit work like business credit cards in that a borrower is approved for a maximum credit limit which they can draw on whenever funds are needed. Monthly payments are determined by the amount of funds currently withdrawn and when the funds are repaid, the borrower can withdraw from the credit line again. A business line of credit can be used to cover cash flow fluctuations, make large purchases, or accommodate unexpected expenses. This type of financing is a great tool for new business owners to build a business credit history, which can help them secure larger financing in the future.
What is a personal guarantee?
A personal guarantee is a document borrowers sign during a loan application process to promise, or guarantee, that the full amount of the debt will be repaid. Personal guarantees work as part of a loan agreement and tell the lender that the individual signing on the dotted line will be responsible for paying off any portion of the loan that the business is not able to repay. Unlike providing collateral, personal guarantees are unsecured because they are not tied to any one asset of the guarantor of the business. Personal guarantees are common with certain term loans and SBA loans, which are partially guaranteed by the U.S. Small Business Administration.
Types of personal guarantees
Not all personal guarantees have the same meaning or have the same impact on the guarantorâs level of liability. When small business owners are asked by a lender to provide a personal guarantee, it is important that they understand what type of guarantee the lender is requiring. A personal guarantee is considered a secondary obligation, which means that the lender must pursue reimbursement from the company first.
- Limited personal guarantee â A limited guarantee lists a specific amount of money that the financial institution can legally come after them for. Limited guarantees are often used by small businesses structured as a partnership on their financial statements because then both business partners can share in the responsibility of repaying the loan.
- Unlimited personal guarantee â Unlimited guarantees mean that if the business defaults on the loan, the lender can go after the guarantor for the entire amount owed, plus interest, legal fees, and financing costs. There are very few personal assets that are exempt from a lender if the borrower signs an unlimited guarantee.
- Indemnity â Occasionally business lenders as for an indemnifier instead of a guarantor. An indemnity is a primary obligation that states the indemnifier must repay the lender if the small business isnât able to adhere to its repayment schedule or if the company is in breach of contractual terms, like being guilty of fraudulent activity.
The pros and cons of using a personal guarantee
When small business owners sign a personal guarantee or ask an interested party to become a guarantor on the businessâs behalf, they are accepting personal liability for the borrowed funds. Just like any other business financing decision, there are pros and cons to providing a personal guarantee.
Pros of providing an unsecured personal guarantee
The most advantageous reason to provide an unsecured personal guarantee with a business loan application is that it increases the chances of being approved. Since the lender has a legal document stating the guarantor is personally liable for the debt, it reduces the lenderâs risk. Being a low-risk loan applicant is also a pro because it also makes the borrower eligible for lower interest rates and smaller down payments. Many borrowers prefer to provide an unsecured personal guarantee over providing collateral because guarantees are not tied to a specific asset like with secured loans.
Cons of providing an unsecured personal guarantee
While providing an unsecured guarantee is often preferred over a secured loan, there are disadvantages to personal guarantees. The primary con of being a guarantor is personal risk. If the business defaults on the loan, it is likely that the business has been dissolved or is not in good financial health. Losing a business is very stressful for entrepreneurs, so the pressure of also being personally liable for the businessâs debt can become overwhelming. Personal liability of a loan guarantee is very structured so if the organizational structure changes or the business is sold, the guarantor can still be held responsible for the debt.
How to minimize risk when providing a personal guarantee
If you are the personal guarantor on a small business loan, you are already aware of the personal risks involved. However, there are some steps guarantors can take to minimize the financial risk of a personal guarantee when reviewing loan offers.
- Communicate â Donât hesitate to reach out to your lender with questions about your responsibilities as the guarantor. Some lenders can work with borrowers to change loan terms, defer payments, or offer refinancing options.
- Insurance â Personal guarantee insurance can help borrowers minimize the risk to their personal finances, by covering up to 80% of a personal guarantorâs liability in the event that the business fails to repay the loan.
- Customize â Personal guarantors can request to eliminate specific assets from the guarantee. Amending the guarantee paperwork to state a specific asset, like the business ownerâs family home, is exempt from being seized can provide relief to the signer.
- Choose co-guarantors carefully â Some entrepreneurs donât own enough personal or business assets to provide the personal guarantee independently, so they seek a co-guarantor. The co-guarantor of a loan can be the small business ownerâs spouse, investor, family member, or friend. Itâs important that whomever you choose as a co-guarantor will be able to carry their portion of the responsibility.
- Consider higher interest rates â Agreeing to sign a personal guarantee is a huge step for borrowers and it can be very risky to their financial well-being. An alternative to providing the guarantee is to talk with the lender about eliminating the need for the guarantee and raising interest rates instead.
How to get financing without a personal guarantee
If youâve decided that providing an unsecured personal guarantee is too much of a risk for your business or for your personal finances, there are ways to secure business financing without becoming a guarantor.
- Consider offering collateral â If you arenât comfortable with the liability assumed with a personal guarantee, consider a secured loan. Secured loans require some sort of collateral to be pledged as a guarantee that the lender will be able to recover all of the issued funds.
- Work with alternative lenders â Alternative lenders, or online lenders, work with several financial institutions at a time. They also have a wide variety of loan products to offer potential borrowers. If a personal guarantee is not for you, speak with an alternative lender, like Biz2Credit, about business loan options that donât require a guarantee.
- Research alternative financing options â Loans are not the only source of business financing for startups and established entities. If youâre having trouble qualifying for an unsecured business loan without a personal guarantee, consider looking into crowdfunding or government grants as an alternative way to fund your business needs.
Signing a personal guarantee is a great way for small business owners to get financing for their businesses at competitive rates. Personal guarantees provide an alternative to secured loans and using personal loans for business purposes. Providing an unsecured personal guarantee on a business loan is risky for the guarantor because they are promising to use personal assets or finances to repay the loan if the business is unable to pay. Whether you are considering using a personal guarantee to secure business financing or are interested in other loan options, reach out to Biz2Credit today to learn how they arranged a cash advance for this digital retailer without requiring a personal guarantee.