Loan Guarantor and Promissory Note

To be a loan maker or a loan guarantor, that is the question.  Here's the answer: most of the time it doesn't matter.  Let's say you want to borrow $100,000 from the bank.  The bank says, fine, but we'll need a loan guarantor who has better credit than you.  Your Uncle Bob has great credit, and he loves you like his own son, so he's happy to oblige.  You then suffer from financial reverses (not you own fault, of course), and you default on your loan. 

The bank can bring a lawsuit against you or Uncle Bob, or both of you at the same time.  Doesn't matter to the bank.  (However, bear in mind that if Uncle Bob pays off the loan, he can sue you to pay him back, or maybe take more radical measures if he belongs to a motorcycle gang.)

Now let's change things just a little.  The bank says, fine, but we'll need a loan guarantor and some security.  You inherited an empty lot in Indio from your Grandmother, and propose it to the bank as security.  The bank again says, fine.

Loan Guarantor and a Promissory note

Now we have a promissory note to the bank with your signature, a loan guaranty of the note to the bank from Uncle Bob, and a deed of trust to the bank with your signature transferring the lot to the bank if you default on the note, which you do. 

This time around, the bank has a number of enforcement choices, and you and Unclle Bob are in different positions. The bank can sue Uncle Bob, but the bank can't sue you based on your promissory note, unless it first forecloses on the lot in Indio.  This is called the security first rule. 

The security first rule goes hand in hand with another rule about how the bank can foreclose on real estate security.  There are two ways to foreclose: first, by an auction sale by the trustee named in the deed of trust, called a trustee's sale; and second, by a lawsuit against you called a judicial foreclosure.

A trustee's sale can be over in as little as four months, and it's cheap.  However, if the bank forecloses on the lot by a trustee's sale, and the lot sells for less than the amount due on the note, the bank can't sue you for the unpaid balance.  The unpaid balance is called a "deficiency."  This rule - no deficiency judgment after a trustee's sale - is one of several anti-deficiency rules in California.

The bank can obtain a deficiency judgment if it goes through a judicial foreclosure.  However, the downside here is worse than the downside of a trustee's sale.  A judicial foreclosure, like any other lawsuit, could easily take a year and cost a pile of money.  Furthermore, when the bank gets its judgment against you and the lot through a judicial foreclosure, the lawsuit really isn't over, because the judgment has two parts.

Under the first part, the bank gets to take the lot, but then there has to be a "fair value" determination by the court that the value the bank assigns to the lot is fair. After that determination is made, the second part of the judgment kicks in.  It allows the bank to pursue you to collect any deficiency.   

But wait!  The game isn't over yet.  If you win the lottery you can buy the lot back from the bank by paying the bank the value of the lot and the deficiency.  This is called a right of redemption.  It's good for a year after the judgment. 

Nobody will buy the lot from the bank until your right of redemption expires.  That means the bank is stuck with your unpaid note and your lot for maybe two years, while it isn't getting any money from you or anyone else.  The bank hates judicial foreclosure.

In this example, the bank will probably utilize your promissory note by foreclosing on the lot by a trustee's sale, which prevents the bank from taking any further action against you.  The bank will also sue Uncle Bob as the loan guarantor.  If Uncle Bob lost his job in the meantime, the bank may settle with him for cents on the dollar, or get nothing from him if he files bankruptcy.  If you weren't too fond of the lot to start with, and if Uncle Bob doesn't belong to a motorcycle gang, you're in good shape. 

Now let's go back to the beginning and find out why I thought all this was interesting.  Let's say you're running a small business as a sole proprietor when you walk into the bank.  If the bank is on its toes, it will ask you to incorporate before it makes the loan, and it will insist that you personally guaranty the loan. 

Assume you do both, and then you default. If the bank believes your other assets are more valuable than your lot, the bank can ignore your lot and sue you on your guarantee, thus avoiding the security first rule, the antideficiency aspect of a trustee's sale, and the headaches of a judicial foreclosure. 

And here's the kicker. Once the bank obtains a judgment against you on your guaranty, the bank can get its hands on your lot after all.  It can enforce the judgment by having the Sheriff sell your lot at auction.  After the sale the Sheriff turns over the proceeds to the bank.

Oh!  One more thing, if you did incorporate your business, the bank can also have the Sheriff seize your stock certificates, and sell your shares at auction.  If nobody else shows up, the bank could even buy them and then liquidate your business. 

Banks love loan guarantors and their guaranty.  If you can possibly avoid it, never guaranty a loan.  Instead, try to secure the loan with non-income producing real estate not likely to rise dramatically in value.  If worse comes to worse, better to have the bank take it instead of all of your assets through the back door.

Carlsbad Real Estate Attorney Stanley D. Prowse is a Real Estate Law Attorney that specializes in California real estate law. We welcome your legal inquiries.