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Guarantees: Assuming the Risk

Published: 23rd January 2015

Author: Jamie Rae, Edmonds Marshall

Published in: Commercial e-Speaking | Issue #39

Guarantees are a common form of credit enhancement often required by banks and other lenders before they will provide finance, including loan advances. Although you’re no doubt familiar with guarantees, this article reminds you of what you need to know and the risks you could be taking if you become a guarantor.

A guarantee is a contract to assume, or to discharge, the liability (or obligation of) a third party. In other words, if you’re providing the guarantee (the guarantor) then you’re promising to pay a debt if the third party (the debtor) does not. If the debtor defaults, you are responsible for repaying the debt to, for example, a financial institution or bank (the lender).

Examples of guarantees

The most common scenario is that a lender requires mum and dad to guarantee the borrowings of an adult child. The child (and this could also include his or her spouse or partner) may want to borrow money to buy a house or start up a business. Before the money is lent, the lender gets the parents to sign a guarantee; the parents may also be asked to authorise a mortgage in favour of the lender as security – that could be a mortgage over the parents’ home or business, or both. Other situations include company directors personally guaranteeing company debt and, likewise, trustees guaranteeing trust debt.

Risks!

Often, particularly in the parent-child scenario, guarantees will be entered into without much thought as to the risk. Granted, there’s an element of human nature at play with parents doing what they can for their children. However, this generosity shouldn’t blind people as to the risks which can be huge. There are cases of guarantor parents losing large sums of money, and even their homes, when their son or daughter defaults on their responsibilities. So entering into a guarantee is not a decision to be taken lightly and without access to the relevant information.

What to look out for?

In practical terms, it’s important that you understand the wording of the guarantee itself and the implications of what you’re entering into. How much are you guaranteeing? Is it a fixed sum or a continuing liability as to whatever may be owing? Be particularly careful with the latter. Why is the debtor borrowing the money? What is it for? What is their income situation and their outgoings? Can they comply with the repayment requirements? Ideally you’ll have a good working knowledge of the debtor’s financial position and the rationale behind the transaction. If you don’t have this information, then ask the appropriate questions before taking the matter any further.

You also need to understand the actual consequences of the guarantee. In short, if the debtor can’t pay the debt, then the responsibility will pass to you. This is fundamental. As guarantor you are essentially stepping into the shoes of the debtor. Their liability is potentially your liability. So, ask yourself, do you have the funds to settle the debt if required? Will that mean selling your home or even being forced into bankruptcy? What’s more, the lender may not give you a choice about this if you have granted a mortgage in favour of the lender over your assets.

Ultimately, after you’ve made the appropriate enquiries and you have doubts about the debtor’s ability to service and repay the debt, common sense would suggest you don’t provide the guarantee. This could be an uncomfortable decision to make in a family-type situation. It does, however, beat the awkwardness of that same guarantee going bad and you being called upon to settle the debt which may involve selling your house and/or your business.

Be cautious about being a guarantor

While guarantees are a very useful tool, particularly for a debtor wanting to ‘get ahead’, as guarantor you should be cautious about entering into a contract such as this, particularly for large sums of money – the consequences of your liability being called upon can be significant. Make sure you have all relevant information about the debtor and the debt itself; not only initially but also on a continuing basis. Ensure you have carefully weighed the potential risks involved against the benefit to be gained by a debtor (usually from having access to a loan) before ultimately deciding whether you ‘go guarantor’. This is not a decision to be taken lightly. Guarantees are legally binding documents enforceable through the courts.

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