India’s economy is woven with threads of small and medium-sized enterprises (SMEs) and they are powerhouses of innovation and job creation and fuel growth across the nation. However, when it comes to financing, SMEs often face a roadblock.

Traditional banks can be wary of extending credit, especially to younger businesses or those with limited track records. This has led to a growing dependence on personal guarantee (PG) loans, a solution that might seem convenient but could be a symptom of deeper financial troubles.

While a personal guarantee loan might seem like a viable solution in the short term, it could be a symptom of deeper financial trouble on the horizon for both the SMEs and the individual business owners who sign on the dotted line.

What are PG loans: A personal guarantee loan is a type of financing where the business owner provides a personal guarantee to repay the loan in the event of business default in repayment. Essentially, the banker is not only assessing the business and financial risk of the business, but also the creditworthiness and net worth of the individual guaranteeing the loan. This means that if the business is unable to meet its debt obligations, the banker can pursue the owner’s personal and private assets.

Why are SMEs turning to PG loans?: Several factors are pushing the owners/promoters of SMEs towards personal guarantee loans. First is the limited access to traditional financing. Banks and other mainstream lenders in India often have stringent eligibility criteria that many SMEs struggle to meet.

This makes personal guarantee loans a tempting option even with higher interest rates and the risk of personal liability. When faced with cash flow issues, or time-sensitive growth opportunities, SMEs need funding quickly and PG loans often have a faster turnaround time compared to traditional loans.

Fault lines

Hidden dangers of PG loans: While personal guarantee loans possibly provide immediate relief, they come with significant risks that SME owners must carefully consider. First, it comes in the form of unlimited personal liability. The biggest danger is that the guarantor’s personal assets are on the line. In case of a default, the lender can legally seize the guarantor’s assets and property to recover the outstanding loan amount. Second is with regard to reduction in credit score.

Failure to repay the loan will negatively impact the guarantor’s credit score, making it difficult to get any other loans like mortgages, or other forms of credit in the near future. There is a possibility that PG loans could push the SME owners towards bankruptcy.

What is the way out?: SMEs should actively explore alternative avenues for funding rather than PG loans. The government offers variety of loan schema specifically designed for SMEs. Such schema often have relaxed eligibility criteria and potentially lower interest rates. For instance, MUDRA loans, Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) to name a few. Another probable avenue is availing factoring services wherein company gets cash in advance against its outstanding debtors.

The increasing reliance on personal guarantee loans by Indian SMEs highlights a need for a more accessible financing landscape. SMEs must prioritise robust financial planning and seek guidance from experts to build creditworthiness and resilience in long term.

Thus, by empowering SMEs with sound financial practices, accessible lending mechanisms, and a diversified funding ecosystem, India can unlock the full potential of this vital economic engine. Ultimately, this will pave the way for sustainable SME growth and safeguard the financial futures of the entrepreneurs who drive them.

Saravanan is a professor of finance and accounting at IIM Tiruchirappalli and Williams is the Head of India at Sernova Financial