Want to be a loan guarantor? Be prepared for a double whammy

Beware of the consequences. In case of default by the borrower, the loan guarantor’s eligibility reduces to the extent of the loan amount. This is apart from shouldering the loan liability   

Proverbs 22:26 of the Bible says, “Don’t promise to be responsible for someone else’s debts”. And this age-old financial advice still stands true even today.

On August 15, the Supreme Court of India ruled that banks should act against guarantors even as proceedings under insolvency code Bankruptcy Code are on. This was with reference to corporate loans. But what if it’s a family member or a close friend asking you to become their loan guarantor? Many times it is simply difficult to refuse.

Rajan Pental, group president and group head - branch and retail banking at Yes Bank said, “Any loan that needs to be secured by more than mere cash flow of the primary borrower, may need a guarantee such as loan against property or working capital facilities for Small and Medium Enterprises.”

In fact, many public sector banks ask for loan guarantors on education loans beyond certain amounts. Sachin Chaudhary, COO, Indiabulls Housing Finance said, “Home financing companies typically only require a guarantor against an applicant in select cases, such as, the lack of a co-applicant, high-risk applicant profiles or weaker financial strength.”

This means if your family or friend is asking you to be a guarantor on a housing finance company loan, you should probably double check the borrower’s repayment capacity before agreeing. Chaudhary added, “It is advisable to only become a guarantor when one is absolutely confident of the applicant’s credibility and ability to repay the borrowed sum”.

Impact on credit score
If you think that being a guarantor is simply about signing a dotted line for a family or friend, think again. Pental said, “One should be cognizant of the fact that the guarantor shares equal liability for repayment of the loan and that in case of default by the primary borrower, it shall be the responsibility of the guarantor to clear all dues to the lending organisation.”

In short, your financial life stands at risks, so does your credit score. Sujata Ahlawat, head of direct to consumer interactive, TransUnion CIBIL said, “Banks and financial institutions ask for a guarantor for certain loans, as a means of security for the loan amount they provide. The guarantor guarantees the lender that he will honour the obligation in case of non-payment by the borrower. Missed payments will not only reflect in the guarantors’ credit report, but will have a negative impact on their credit score as well.”

Remember the borrower’s, as well as yours, that is, the guarantor’s credit reports will mention you are the guarantor. Vaishali Kasture, Managing Director and Country Head, Experian India said, “Being a guarantor, one is legally responsible for the borrower’s debt. When lenders share information on the loan performance, details of guarantors are also shared along with that of the main borrower. These automatically get reflected on one’s credit report along with the complete credit history. In case of non -repayment, the guarantor’s credit score is also affected along with that of the primary borrower. A low credit score will impact and cause hurdles while applying for loan in future, for both parties.”

This means in case the borrower defaults; your credit score takes a hit and, hence, hurts your future loan eligibility. But, that’s not all, whenever you agree to become a loan guarantor for someone, your loan eligibility actually gets reduced. After all, when you are a guarantor for someone, the bank usually reduces your eligibility to the extent of guarantee you have stood for, since that liability can be shifted to you in case of default by the original borrower. Pental said, “For approving someone as a guarantor, Banks usually appraise the guarantor for credit worthiness, reputation, net worth and relationship of guarantor with borrower.”

Before becoming a guarantor
Banks do their due diligence regarding the guarantor as well. It’s wise that you do your bit. 

Firstly, remember while it is important to be well-informed of one’s own financial profile, it is equally important to understand the credit profile of the individual you choose to be a guarantor for. Kasture said, “As a guarantor, you carry an obligation under conditions where the main applicant is unable to repay. This could leave a long-term impression on the guarantor’s credit worthiness, hence, it’s imperative to understand the persons financial and credit behaviour.”

Secondly, while undertaking a guarantee it’s not enough to know the person. Asking questions to do complete due diligence on the borrower is equally important. Understand why they need a guarantor and how they plan to pay off the loan.

Thirdly, Ahlawat said, “Consider carefully before agreeing to become a guarantor, and keep track of how many loans you are guaranteeing. This can impact your credit score, access to credit and eventually your financial goals.” If you can’t say no when someone asks you to be their loan guarantor, remember you might get into serious trouble even if one borrower defaults.

Fourthly, even if you are a guarantor to one loan, monitor your credit report and score regularly to check the loan repayment status and identify if anything is amiss.

Kasture said, “Have a clear understanding of the motive behind the credit undertaking. Research and read around his/her past credit behaviour.” Urge primary borrowers to monitor their credit report and score, too, and reduce over-leveraging of their credit limits. This will help them keep track their credit exposure and verify correct loan repayment information in their reports.

If the borrower defaults, banks would first try and recover the debt from the borrower. But, if that doesn’t work, the guarantor will get a notice next. As the guarantor, you can ask the bank to sell the borrower’s property and recover the dues. Or you can pay the dues to save the property. But if you don’t have the required funds, you may even have to take a loan for the same. 

Hence, it makes sense, to avoid such huge financial liability, even at the cost of sounding rude to a family member or friends.

Source: DNA Money