Full recourse vs. personal guarantees
When it comes to private money loans, you’ll often hear the terms “full recourse” and “personal guarantee” in tandem. However, they mean very different things with distinct legal nuances. Lenders require them in order to have further assurance that you’re committed to the project’s success. You will sometimes hear lenders refer to this as “having skin in the game.”
Most importantly, remember this: while full recourse loans and personal guarantees are common to private money loans, as with everything, they are negotiable.
What does full-recourse mean?
A full recourse loan means that if the collateral is not worth enough to cover the full amount of the debt, a lender can pursue the borrower to collect on other assets. Depending on your contract, the borrower may be:
- Your personal assets if the loan is in your name.
- The entity under which you titled the property.
Most real estate investors title assets in separate LLCs to guard against the full recourse nature of most commercial loans. A full recourse loan is limited to the assets owned by the LLC. If the LLC owns no other assets, then the lender has no authority beyond the collateral.
It’s important to remember that this limitation on full-recourse loans will likely only hold up if you don’t co-mingle funds across entities. Many real estate investors negate some of the protections of LLCs by moving funds inappropriately between LLCs to fund projects. A CPA can provide more information on this, as co-mingling funds can also get you in trouble with the IRS.
Hard money and commercial lenders are familiar with this “workaround” and so many will also require a personal guarantee.
What a personal guarantee entails
Where a full-recourse loan pertains only to the borrower listed on the contract, a lender may require a personal guarantee from the individual or other related entities. This allows the lender to pursue multiple avenues to collect if the foreclosure and resale doesn’t satisfy.
There are three main kinds of personal guarantees:
- An unlimited personal guarantee is one in which the issuing entity (borrower) promises to pay the entire outstanding loan amount plus legal fees, accrued interest, and costs associated with collecting on the debt. The lender will first exhaust their remedy by foreclosing on and selling the collateral. If the lender is unable to collect the full amount, they will look to the borrower’s personal assets to recover the unrealized balance.
- A limited personal guarantee sets a dollar limit or some other limit on the borrower’s liability. Limited personal guarantees are common when a loan involves several company shareholders. Be aware that limited guarantees often contain a “fraud” clause. This clause converts an otherwise limited guarantee to an unlimited one if fraud is involved. You’ll sometimes hear lenders refer to fraud clauses as “bad boy” clauses.
- A conditional personal guarantee requires a “trigger” event to take place in order for the guarantee to be valid. For example, a low loan-to-value with minimal risk may only invoke the guarantee when the borrower fails to meet certain conditions during the course of the loan. The lender must specifically outline these condition in the contract in order for them to apply.
Keep in mind: ownership of the note can change.
The private money lender may not be the person or entity that enforces the personal guarantee or full recourse loan. It is a mistake to think you do not have to pay attention to the contract language because of a longstanding relationship.
Lenders sometimes sell non-performing notes at the first sign of trouble so they can cut their losses quickly. They may even sell performing notes if they need fluid cash. When negotiating your guarantee and full-recourse loan, think how a stranger may try to enforce actions. While they must still follow your existing loan contract to the letter, this fact may change the light under which you negotiate terms.
One of the benefits of obtaining a private money loan is that everything is negotiable. Look at your project from the lender’s position. The goal is to find a win-win that allows the lender to get a return for their investment risk while you receive the favorable terms.