When you guarantee a loan taken out by your business, friend, or family member, you make yourself liable for it if the borrower doesn't pay. Luckily, you can usually wipe out your personal liability for debt through bankruptcy—including a personal guarantee you provide for your business. Read on to learn more about personal guarantees, including:
If you're a business owner, learn more about bankruptcy and small businesses.
A personal guarantee is an agreement that allows a lender to go after your personal assets if your company, relative, or friend defaults on a loan. For instance, if your business goes under, the creditor can sue you to collect any outstanding balance.
Banks often require that a new business put up collateral to secure repayment of business loans. But most new companies don't have much in the way of assets. To increase the odds of getting paid, your lender will often require a personal guarantee from you or from someone else before extending a property loan or another obligation, such as a lease contract or extension of credit for goods. If the business fails, the lender has two remedies to satisfy an outstanding balance: It can go after the business assets, if any, and the personal assets of the person who signed the guarantee.
Many entrepreneurs structure their business as an LLC or corporation, in order to protect their personal assets if the business defaults or otherwise doesn't live up to its financial obligations. Lenders and landlords have a way of getting around those walls by demanding a personal guarantee.
Whether your lender will require a guarantee on your personal loan depends a lot on the type of loan and whether you can pledge collateral to ensure payment. Guarantees for personal loans were more common before credit cards became popular and a consumer's repayment habits could be tracked. Today, a lender will require a guarantee if a borrower doesn't have much of a credit history, has a low credit score, or is borrowing a lot of money. For instance, guarantees are common when someone wants a high-dollar personal loan but has no collateral to secure it, and when a young adult buys a car or takes out a student loan.
Before filing a bankruptcy to eliminate your obligation under a personal guarantee, it's a good idea to consult with an attorney to determine whether the guarantee is still valid, or if it can be challenged in other ways. For instance, if you guarantee a loan for a relative, and the bank changes the terms of the loan without notifying you, the bank may lose its right to enforce the guarantee against you.
Another common issue arises when a spouse isn't involved with the business, but the bank requires that the spouse guarantee the loan anyway. The spouse's guarantee might not be enforceable if it's unfair.
Bankruptcy can eliminate a personal guarantee on both business loans and personal loans.
Guarantees on Business Loans: It's relatively common for a business owner to file individual bankruptcy to get rid of a personal guarantee—and most personal guarantees will qualify for discharge. If it's a nondischargeable debt, however, bankruptcy won't help. For example, suppose the sole proprietor of a restaurant gave the bank a false financial statement when she applied for a loan. Later she filed for bankruptcy, and the court declared the bank debt nondischargeable. Even if the guarantee was discharged, the restaurant owner remained liable on the bank loan because it was nondischargeable. So, the bankruptcy didn't relieve her of the obligation to pay the debt.
Now, suppose you file for bankruptcy on behalf of the business, not yourself. The business's bankruptcy won't get rid of your personal obligation to pay back the guaranteed loan. In fact, in that situation, the personal guarantee will work against you. The trustee appointed to oversee the case will likely view the personal guarantee as a business asset and look to you and your personal assets for money to pay the business's creditors.
Guarantees on Personal Loans: Similarly, if you signed a personal guarantee for a friend or family member's loan, you'll still be on the hook if they file for bankruptcy. You'll either have to pay off the debt or file your own individual bankruptcy to get rid of the obligation. The exception is if the friend or family member pays off the debt in Chapter 13.
Most banks won't consider dropping the personal guarantee on a business loan until the loan is paid off. To avoid the need to file an individual bankruptcy, you could consider taking out a personal guarantee insurance policy. If you're forced to use your personal assets to pay off the business loan and satisfy the personal guarantee, the insurance policy will reimburse you up to 80% of the amount you had to cover, which might be enough to satisfy the lender and help you avoid a bankruptcy filing.
Some personal guarantees include a security interest in your personal assets. In that case, the lender will typically have a lien on your property. A bankruptcy discharge will wipe out only your personal obligation to pay back debts—not the lien. The lien will allow the lender to foreclose on or repossess the collateral regardless of your bankruptcy discharge. Even so, remedies exist depending on the chapter type you file (more below).
No two bankruptcy cases are the same in terms of issues and facts. It's common to have a lot of moving parts and considerations, so it's best to meet with a bankruptcy attorney. The sections below explore how the different types of bankruptcy treat personal guarantees.
If you have a lot of debt but not much in the way of income or property, Chapter 7 will likely be your best option. You can wipe out (discharge) qualifying debt, such as credit card debt and personal guarantees, in approximately four months. If you have nondischargeable liability, such as a domestic support or tax obligation, you might be able to pay it over time by filing Chapter 13 immediately afterward. This strategy is known as Chapter 20.
Chapter 7 also works well if you have a substantial income, and the majority of your debt is business debt. Here's why. The means test measures your income and can prevent you from filing for Chapter 7 if your income is too high. However, when most of your debt is business-related as opposed to consumer debt, you aren't subject to the Chapter 7 means test income qualification. This can be a huge benefit for someone with a personal guarantee liability.
For instance, suppose that you still owe a significant amount of debt due to a personal guarantee from a failed business. However, now you're making a sizeable income working for someone else. You might be able to discharge your debt quickly using Chapter 7, despite a salary that would generally preclude you from filing (assuming, of course, that you aren't concerned about losing property in Chapter 7). Find out if you're exempt from the means test.
Often when you buy something on credit, like a new bedroom suite or an engagement ring, the law grants the seller a lien, called a nonpossessory purchase money lien. In Chapter 7 bankruptcy, the debt will be discharged but the lien won't. Therefore, you'll still owe the debt after the bankruptcy is concluded. You might be able to eliminate this lien if you meet all three of these conditions:
This applies only to certain types of property to the extent the lien prevents you from using an exemption. Exemptions are the laws that allow you to protect property in bankruptcy.
These liens can be avoided on assets such as tools of your trade, household goods and furnishings, jewelry, and professionally prescribed health aids. You can't avoid a lien on your house or car (unless the vehicle qualifies as a tool of the trade like a delivery truck).
Many business people find this chapter helpful in several situations. You as an individual, not the business, would be filing Chapter 13—companies can't file. Unlike Chapter 7, you can keep all of your property, and in most cases, you'll pay a smaller portion of your personal debt over time. Here are a couple of examples that illustrate how Chapter 13 can help.
Chapter 13 has a few other benefits that aren't available in Chapter 7. If you're like many business people, you might have fallen behind on a house or car payment while trying to keep the company afloat. You can catch up on these payments through the Chapter 13 repayment plan and keep the home, car, or other secured property. You can also get rid of a wholly unsecured mortgage on your home using a lien strip, or reduce a 910-day old car loan balance.
Also, you might be able to reduce the amount you'd have to pay on some collateral through a cramdown in Chapter 13 bankruptcy. For instance, you can reduce the balance owed to the property's actual value on some personal property, or even a business or rental property. The catch is that you'd have to pay off the reduced loan amount through your plan.
Find out about the steps in a Chapter 13 case.