Assuming the risk
Guarantees are a common form of credit enhancement, particularly in these post-global-financial-crisis times. Banks and other financial lenders regularly require personal guarantees before entering into a transaction, for example, if they’re providing a loan. What if you are asked to provide a guarantee? What do you need to know and what are the risks?
A guarantee is a contract to perform the promise of, or to discharge the liability or obligation of, a third person. In other words, the person providing the guarantee (the guarantor) is promising to pay a debt if the third person (the debtor) does not. If the debtor defaults, the guarantor is responsible for repaying the debt to the creditor.
The most common scenario is a lender, usually the bank, requiring mum and dad to guarantee the borrowings of an adult child. The child (and this could also include his or her partner) may want to borrow money to buy a house or start up a business. Before the money is lent, the lender ensures the parents sign a guarantee along with possibly authorising a mortgage in favour of the bank as security. Other possible situations include company directors personally guaranteeing company debt and, likewise, trustees with trust debt.
Often, particularly in the parent-child scenario, guarantees will be entered into without much thought as to the risk. There are cases of guarantors losing huge sums of money, and even their homes. So entering into a guarantee is not a decision to be taken lightly. These are legally binding documents that are enforceable through the courts. This is why you should get independent legal advice before signing any guarantee document.
It’s important you understand the wording of the guarantee itself. How much are you guaranteeing? Is it a fixed sum or a ‘continuing’ liability as to ‘whatever may be owing’? Be careful with the latter. Why is the debtor borrowing the money? What is it for? Can they comply with any repayment requirements? Ideally you will have a good working knowledge of the debtor’s financial position and the rationale behind the transaction.
You also need to understand the practical consequences of the guarantee because if the debtor can’t pay the debt the responsibility will pass to you. Do you have the funds to settle the debt if required? Will that mean selling your home or even being forced into bankruptcy? You must ask yourself whether you have any doubts about the debtor’s ability to service and repay the debt. If you do, common sense would suggest you don’t provide the guarantee.
In short, be wary about entering into guarantees, particularly for large sums of money, as the consequences of your liability being called upon can be significant. If you’re giving a guarantee, 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’.
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