Should You Become a Loan Guarantor for Your Family or Friends?

March 4, 2022 Mutual Fund

At some point in time, a family member or a friend might have asked you to be a guarantor for a loan. While helping your close ones in their time of need, you should always remember that money could make or break your relationships. So, what should you do when you get an innocent request from your family member or a friend to be a loan guarantor? Read on to know why you should or should not be a loan guarantor for your close ones…

A request to sign up as a loan guarantor for your friend or family member does seem like no big deal as you only need to make a couple of signatures, and that’s it. Although it is correct that you do not have to do much and the process is quick, it is a huge financial responsibility and carries significant risk too.

What does it mean to be a Loan Guarantor?

A loan guarantor is a person who is willing to take responsibility for the dues in case the primary borrower fails to make the repayment or intentionally defaults on the loan.

Generally, a loan guarantor enters into an agreement with a trust that the primary borrower will timely repay the loan amount. However, there could be the chances of a failure to timely repayments due to any reason. In such a case, the guarantor will be liable to repay the loan.

Besides, the late payments or EMI bounces of the primary borrower can negatively impact the credit score of the guarantor.

Here are a few questions to ask yourself before deciding to become a loan guarantor:

1. Why does a bank ask for a loan guarantor?

A bank does not ask for a guarantor for all types of loans and to all the applicants. Since secured loans like home loans, car loans, etc. are backed by collateral, these loans generally do not require a guarantor. So, the bank typically asks for a guarantor to unsecured loan applicants with a low to average credit score, weaker financial position, high debt-to-income ratio, or inadequate income. This ensures the bank recovers the credits issued to the risky borrowers.

2. What is my potential liability?

A loan guarantor could be of two types – financial or non-financial. A financial loan guarantor is a common type of guarantor who is equally responsible for full legal repayment of the loan if the primary borrower fails to repay. So, if the primary borrower defaults, the bank will ask you, the guarantor, to repay the outstanding loan amount.

Whereas a non-financial loan guarantor acts as a communicator between the bank and the borrower to make the recovery process easier. This type of guarantor is typically helpful to banks in case of the NRI loans to have a local point of contact. So, the bank contacts the non-financial loan guarantor to trace or get in touch with the borrower in case of delayed repayments or defaults instead of asking them to repay the loan.

3. How can it affect me?

As discussed earlier, you will be liable to repay any outstanding loan amount in case the borrower defaults. However, if you are unable to repay the loan, in the worst scenario, the bank has all the rights to sell your property to recover the dues. Apart from this, delayed repayments and defaults will lower your credit score, which will ultimately lower your chances of getting a loan in the future. Hence, if you already have a low to average credit score, it is not advisable to be further exposed to vulnerability.

4. Why the borrower needs a loan guarantor?

As we discussed, the banks do not ask for a guarantor unless the borrower has a low credit score or weaker financial position to avail of a loan. It might not prove to be a good decision if you agree to be a loan guarantor for your friend or family member who does not have a good credit history or have a high debt-to-income ratio. Hence, you should check for the reasons why the bank is asking for a loan guarantor and check the creditworthiness of the borrower. It is advisable to sign up to be a loan guarantor only if you are satisfied with their creditworthiness and capacity to repay the loan. If they fail to repay the loan and the repayment burden falls on you, it can sour your relationship.

5. Do I have a contingency plan?

Even if you are satisfied with the creditworthiness and repayment capacity of the borrower, you should ask yourself if you are financially prepared to repay the loan if the borrower fails to repay it. You must consider your creditworthiness, repayment capacity, loan amount, income, debt-to-income ratio, short-term and long-term financial goals, etc., and give it a go only if you are financially prepared and have a contingency plan to repay the loan if things don’t go as planned.

6. Can I get out of the agreement in the middle?

Any type of loan is a long-term commitment, and hence you cannot get out of the loan agreement until the entire dues are repaid. However, you can offer a bank a replacement for you, who is equally capable of repaying the outstanding amount. The banks will most probably consider your request if you offer a strong replacement.

7. How can I reduce the risk?

Before signing up to be a loan guarantor, you can take a few precautions to reduce your financial risk. If possible, ask your friend or family member (borrower) to buy loan insurance, which will take care of the outstanding amount in case they fail to repay it. It is also advisable to ask them to provide collateral (or secondary collateral if one collateral is already given) to lower your chances of facing the burden of repaying the loan.

To Conclude:

After answering all the questions mentioned above, you might have come to the conclusion of whether you should or should not be a loan guarantor for your friend or family member. If you need to be a non-financial loan guarantor for your family member or close friend, rest assured there is no financial risk involved, but the borrower should be easily contactable. Being a financial loan guarantor comes with a huge financial responsibility. Hence, it is advisable to avoid being a loan guarantor unless it is for your spouse or a friend/ family member who has a good creditworthiness and repayment capacity. Furthermore, make sure you have a contingency plan to repay the outstanding amount in case the borrower fails to repay the loan. You should be responsible for your decision to be a loan guarantor and not let the relationship go sour if the primary borrower defaults on the loan.

This article first appeared on PersonalFN here