Guarantee vs. Collateral: Everything You Need to Know
A personal guarantee promises to repay back a loan while collateral is a good or an owned asset that you use toward loan security.3 min read
Guarantee vs collateral — what's the difference? A personal guarantee is a signed document that promises to repay back a loan in the event that your business defaults. Collateral is a good or an owned asset that you use toward loan security in the event that your business defaults.
Understanding Personal Guarantees, Collateral, and Liens
Should you default on a loan and a lender decides to take action, a personal guarantee will permit the lender to seize your personal assets. Similar to a mortgage or auto loan, a lender will hold the title of the home or vehicle until the debt has been fully paid.
Often, lenders will require some type of collateral when a small business loan is offered. Consider it a form of temporary ownership of your asset while you repay a loan. To clarify, this means that you are permitting a lender to have possession of your collateral in order to cover the debt in case the loan defaults.
Lenders have specifications on the forms of collateral that qualify. For example, assets must ensure the following:
- Easy for a lender to value.
- Easy for a lender to liquidate.
A lien is a public notice of an owed debt posted by a creditor. In the event that an individual fails to pay a creditor, liens permit a creditor to sue in order to collect the outstanding debt. If the creditor wins, the lien legally allows them to seize your personal assets to cover the debt. Lenders use collateral, liens, and personal guarantees to minimize the risk of loss should you default on a loan.
What Is a Personal Guarantee and How Do I Negotiate One?
A personal guarantee is a promise to repay a loan to a creditor that's backed by personal assets. When establishing a business loan, your lender will typically ask you to sign a document verifying that you will personally repay the loan if your company goes bankrupt.
In the event that a business can't pay back the loan, a personal guarantee grants the lender permission to liquidate the personal assets used to cover the debt. Typically, this includes items such as a car, home, and personal funds from a private bank account.
Personal Guarantee vs. Collateral vs. Liens
It is important to understand the terminology associated with business loans. As a business owner, there are three key terms that are associated with this process:
- Personal guarantee: This is a signed promise that states that you will pay back your loan through personal assets that aren't legally protected from creditors.
- Collateral: If a business defaults or goes bankrupt, collateral is a particular asset or assets that are pledged as security for repaying the borrowed loan. A lender is authorized to seize collateral and sell it to reclaim borrowed funds. For example, collateral can be personal assets such as cars and homes, business assets such as equipment and machinery, or a combination of both.
- Lien: A legal method by which a lender can take hold of your collateral in the event that your business goes bankrupt and you can't repay a loan. For example, if your home was declared as collateral for a loan, a lender will place a Uniform Commercial Code (UCC) lien on it.
Large loans are ensured with both a personal guarantee and collateral. If you independently establish a loan with personal collateral and default on it, then the lender will typically foreclose the collateral and attempt to collect the remaining balance from you personally. Remember, if another entity or individual guarantees your loan, then that party is also personally responsible for the amount of debt that was assured. However, if there is collateral involved, a lender will foreclose on it first and attempt to collect funds from you and any other parties involved with the loan.
Consider that if you sign a personal guarantee when securing a business loan, you are essentially agreeing to pay back the loan using personal assets if the business cannot pay it. However, if you do not sign a personal guarantee and instead use collateral, then the lender may collect the collateral and sue the company for the remaining funds, but personal property cannot be seized.
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