Potential Risks of Being a Guarantor
Being a guarantor can be a great way of helping someone you know to take out a loan if they have a poor credit history. A guarantor acts as a third party offering security for the loan, typically through ownership of property, and through a strong credit history. Guarantor loans are often used to secure a mortgage, or for someone taking out a fixed term rental contract on a property, as well as for personal loans. However, and while guarantor loans are a valuable way to help borrowers, there are some attendant risks that need to be considered before becoming a guarantor.
What is a Guarantor Loan, and Who is Eligible to Be One?
A guarantor loan is a legal agreement whereby a loan is approved between a bank or lending agency and a borrower on the assumption that a third party will cover the loan if the borrower defaults. The guarantor effectively makes the loan a secured one through their property and agreement to repay the loan. As a result, the secured loan can produce more favourable interest rate levels for the borrower, and more confidence by the bank in the repayment of the loan.
In terms of eligibility, a guarantor typically has to be a homeowner, or someone with significant savings and a positive credit history. In most cases, a guarantor is a parent and spouse, and sometimes a sibling or grandparent. The guarantor should be able to cover the loan without there being personal problems. The borrower, once receiving their loan, are then able to make repayments that will improve their credit rating and allow them to take out future loans without the need for a guarantor.
However, while the ideal situation would be for the guarantor to act as a third party that doesn’t have to contribute any money to a loan repayment, there are some dangers. A guarantor can be placed into a situation where they have no control over the maximum amount of funds that the borrower takes out, or is liable for. The principle of the initial loan may fluctuate and take on higher costs, of which a guarantor may find themselves liable to pay. In this context, a contract between a guarantor, a borrower, and a lender should always be carefully designed to prevent the guarantor from being stuck with an unlimited guarantee for defaulted loans.
Worst Case Scenarios
There are some worst case scenarios that need to be considered for a guarantor. Primarily, a guarantor may have to pay all of a loan repayment if the person defaults, which can be substantial if tied to a mortgage. In this way, the guarantor may have to either remortgage their own property, or have it repossessed as a way of covering the damages. While this is a worst case scenario, a guarantor must be aware of the risk. Moreover, having to repay a loan can mean that a guarantor’s own credit rating suffers if they have associations with poor credit, and can result in mounting bills elsewhere, whether in terms of mortgage or other loan requirements.
Again, it’s important that a guarantor is ideally a close family member that trusts and is unlikely to be separated from the borrower, to the point that they become legally responsible for their errors. Consultation with a bank or lending agency prior to making a guarantor arrangement is vital to ensuring that an agreement is drawn up where all parties understand the risks involved.