What is a personal guarantee?
A personal guarantee is a legal commitment made by an individual to repay a loan or debt if the primary borrower, such as a business or trust (in this case, an SMSF), fails to repay the loan. In other words, if the entity taking out the loan cannot repay it, the lender can pursue the individual who provided the personal guarantee to recover the debt. This guarantee is often required by lenders to reduce their risk, especially when lending to entities that may not have sufficient assets or credit history on their own.
When you sign a personal guarantee, you are pledging your personal assets — such as your home — as security for the loan. This means that if the primary borrower defaults, your personal assets could be at risk. Personal guarantees are commonly used in business loans, and self-managed super fund (SMSF) loans.
Why do SMSF loans use personal guarantees?
The rules for borrowing money via an SMSF are fairly strict due to the nature of superannuation. The Superannuation Industry Supervision (SIS) Act details that SMSFs may borrow money under the following conditions:
- – Borrowing for specific assets: The borrowed money must be used to buy a single asset (like a property — but not a house or land package) or a group of identical assets with the same value (like a collection of identical shares).
- – No borrowing for improvements: The borrowed money cannot be used to improve the asset, including major renovations to a property.
- – Asset held in trust: The asset bought with the borrowed money must be held in a separate trust, called a bare trust, giving the SMSF a beneficial interest in the asset. This basically means the trust holds the asset until the loan (called a limited recourse borrowing arrangement or LRBA) is repaid.
- – Limited recourse: If the SMSF defaults on the loan, the lender can only claim the asset purchased with the borrowed money. They cannot go after other assets of the SMSF.
- – Restrictions on charges: The asset cannot be used as security for any other purpose beyond the borrowing arrangement — this means you cannot refinance a property inside an SMSF to release equity.
The point about limited recourse is one of the main reasons a personal guarantee may be necessary to secure an SMSF loan. This is because the lender cannot repossess any of the other assets held in the SMSF. This protects the SMSF’s other assets, however, it leaves the lender exposed in the event that the SMSF does not repay the loan. While the lender does have recourse over the asset held in the bare trust created by the LRBA, the value of the property may not be sufficient enough to cover the outstanding loan. To ensure the lender is able to recoup its finances in the event of the borrower defaulting, a personal guarantee from the fund members may provide the appropriate level of security required by the lender.
When would a lender call upon a personal guarantee?
If your super fund makes its regular loan repayments for the duration of the SMSF loan, then the lender would not need to seek recourse, and the property would be transferred directly to the SMSF once the loan is fully repaid.
In the event that the SMSF defaults on the loan — which means they cannot repay the loan — the lender may need to repossess assets to recoup their funds. If the value of the property that was purchased with the loan is high enough to repay the debt in full, the lender will not need to call upon the personal guarantee. However, if for whatever reason the value of the property was not high enough to cover the outstanding debt, the difference would then be covered by the individual who gave the personal guarantee — if the individual cannot come up with the cash to repay the debt, their home could be at risk.
When lenders assess an SMSF loan application, they very carefully check that the fund has sufficient cash flow to afford their loan repayments. So at the end of the day, as long as the fund keeps on top of repayments, you won’t have anything to worry about by providing a personal guarantee.
How are personal guarantees treated in the super environment?
If the super fund is not able to repay an SMSF loan and the guarantor chooses to make a payment to cover the debt (rather than seeing the SMSF default on the loan and the asset being acquired by the lender), this amount will count as a contribution to the SMSF where it pays out the liability. This might be the outcome where the guarantor (or SMSF member) pays out the outstanding debt, resulting in the asset being transferred to the SMSF.
For example, John’s SMSF cannot keep on top of the SMSF loan repayments. John does not want to see the property acquired by the lender, so John chooses to repay the remainder of the SMSF loan from his own pocket. The loan is repaid in full, so it’s transferred from the bare trust over to the SMSF. The amount John paid is counted as a contribution to the SMSF.
No contribution is recorded when the guarantor or trustee chooses to walk away from an SMSF loan shortfall (resulting in the asset being acquired by the lender) but the lender calls on the guarantee to cover any shortfall after the original asset has been sold. The trustee will need to cover this shortfall, but it does not count as a super contribution.
For example, John’s SMSF is falling behind on repayments. John knows that the lender does not have any legal recourse of the funds other assets, so he watches the SMSF default on the loan, without intervening. The lender acquires and sells the property but the proceeds from the sale are not high enough to repay the full amount of the debt. The lender then exercises their right to call on John for the remainder of the debt. This remaining amount that John is now personally liable for, does not count as a contribution to the super fund.
We can help
At SMSF Loan Experts, we’re well-placed to help you understand all of the details surrounding SMSF loans and personal guarantees. At the end of the day, a personal guarantee helps the lender see the loan as lower risk, which can even help secure more favourable loan terms. If you’d like to learn more about personal guarantees or purchasing property through your SMSF, please reach out to us for a chat.
