What Happens When You Default On A Loan You Personally Guaranteed?
In addition to the property securing a loan, a personal guarantee is also used a promise or agreement to hold you personally liable for a debt. By personally guaranteeing a loan, in addition to the property as collateral for the loan, the Lender also has recourse against you personally. They can go after other assets you own under these terms. Lenders prefer these types of loans. It gives them something of value more than the asset, which has the loan against it. It also gives them more security. It lets a lender feel you will take better care in managing the investment to ensure its success.
The personal guarantee will typically not come into play unless the asset which is foreclosed upon, will not cover the liability/outstanding balance due the lender. This balance can be substantially higher than the loan balance, as it also typically takes into account the penalties, accrued interest, and legal fees a lender may incur.
In some cases, you can discharge your liability for a personal guarantee by filing for bankruptcy relief (unless the guaranteed debt itself is non-dischargeable). However, keep in mind the bankruptcy will need to be a personal bankruptcy to potentially eliminate any personal guarantees, and not just a bankruptcy for the asset.
If your personal guarantee includes a security interest in your personal assets, the lender will typically have a lien on your property. A bankruptcy discharge may only wipe out your personal obligation to pay back debts. It doesn’t eliminate liens. This means the lender may still be able to foreclose on or repossess any of your personal assets it has a lien on, regardless of your bankruptcy discharge.
Be aware if you do choose to file bankruptcy, your credit score will likely drop significantly after defaulting on a loan. It will make it more difficult to secure credit/debt in the future. Even if a lender is willing to take a risk on someone which has previously defaulted on a loan, the interest rate will most likely reflect that by a significant increase in the rate!
Here are a few tips that you want to consider to help spread the risk on a loan that is personally guaranteed.
Don’t bet the entire farm – Carve out certain assets the bank can seize but protect others assets ie: your main residence. There are states that have a Homestead act that allows you to protect your personal residence like California, Florida and Texas but there are also other means to protect your personal residence if your state doesn’t have a Homestead Act, and you will want to be sure to write the provision into your personal guarantee if the bank will accept it.
Try Too Shorten timeframes – Many personal guarantees are signed “unconditionally and forever” for the term of the loan, but you want to try to negotiate an end date. Ie: request that the terms of the personal guarantee only apply to a portion of the time frame you are given to pay back the loan. You can also attempt to negotiate an end-date on certain provisions of the personal guarantee or even offer to make payments, or additional payments on time each month and have a portion of the personal guarantee be forgiven.
Spread Your Risk – If you have a spouse it is always best to avoid having your spouse sign the personal guarantee, thus protecting the assets that are not owned jointly, especially if you live in a community property state. Another good example is if you have multiple investors that own a percent of the business you should request to have each investor be part of the personal guarantee so it’s not just your liability.
Limit The Amount That You Guarantee – This is a tough one but worth giving a shot, try to request that only a portion or percentage of the loan be covered by the personal guarantee.
Have legal counsel review and negotiate the loan documents – Finally, have an attorney that specializes in real estate loan documents review the documents before signing, and negotiate the terms that may be overly broad or cumbersome. This is a step that is often overlooked by many investors, but should not be taken for granted, after all an ounce of prevention is worth more than a pound of cure!
In the end you want to really step back and see if a personal guarantee is the best move for you as it can get to be a tough situation for you if things go bad, expect the best but prepare for the worst!