Before we discuss the need for a personal guarantee for loans let us understand what guaranteeing a loan means. When somebody borrows money or takes a loan that person has to pay the amount back with interest within the stipulated time. The lender will ascertain the creditworthiness and the reliability of the borrower before lending the amount so that they do not stand to lose the amount lent due to default by the borrower. However there might be instances when the bank may not be satisfied with the credentials of the applicant and may require some extra assurance before they lend to the applicant. This is where a guarantor steps in. Guaranteeing a loan means that the guarantor provides surety for the borrower; thus if the borrower fails to pay up or defaults the person who has provided a guarantee will be asked to pay.
Guarantee is a contract that is defined in the Indian Contract Act as “a contract to perform the promise, or discharge the liability, of a third person in case of his default.”
Why is a Guarantee Required?
As we discussed above a guarantor acts as a fall back option or surety in case the borrower fails to fulfill his/her obligation. So now we come to the question why banks require a personal guarantee? Application for education loan often needs to be accompanied by guarantee of a parent or a guardian so that in case the student is not in a position to repay the loan (or there is delay in getting employment after course completion) the bank is assured of getting its money back as there is a surety involved.
Lenders try and ascertain the creditworthiness of the customer by accessing the applicant’s credit report to assess if the borrower can repay the borrowed amount. They also require documents like salary proof apart from the address and identity proof to ascertain the authenticity of the borrower and also establish if he/she has sufficient income flow to bear the EMI burden. However if the bank feels that the income of the applicant is not sufficient or they find some lack in documentation they can ask the applicant to get a guarantor so that the loan can be sanctioned. The guarantor provides an extra security for the lender. Getting a loan for CIBIL defaulters may not be an easy task; again a guarantor can be of help here. However it is important to mention here that getting a loan with low CIBIL score sometimes may not be possible even with the help of a guarantee. Whether a bank sanctions a loan in such an eventuality will solely depend on the discretion of the bank, type of loan, amount of loan and other documents provided with the loan application. The nature of default will also impact this decision.
Sometimes personal guarantee may be required in case of business loans too. The bank may ask the primary member to give a personal guarantee even if the privately held company that is seeking the loan is in good condition and there is adequate security for the loan. This is done to safe guard the lender against defaults which may be huge. In light of default by some businesses in recent times this seems like a step in the right direction. The bank may be left with huge NPAs while the promoters may continue to enjoy in the comfort of their stowed away wealth. Taking a personal guarantee will ensure that the promoter is at all times fully invested in repaying the company loan as he/she knows the a default can singe his/her personal empire too.
What a Guarantor Must Know?
The lenders take a personal guarantee to keep them safe from having to bear the brunt of a default. However the guarantor should also be aware of what he or she is signing up for. A default by the borrower means that the guarantor has to be pay the due amount so one should guarantee a loan only if they have sufficient resources to pay the required amount. One should guarantee a loan only for a person who they know or trust. In case of a business loan if they should do so if they are sure that the business plan is sound and that the business is being run professionally. It is also important to remember that default on a loan which you have guaranteed will impact your CIBIL rating just like a default on your own loan will.
A personal guarantee works for both the lender and the borrower as a borrower is able to access a loan which he/she might not be able to otherwise while the lender is assured about the safety of their money. For the guarantor it is important to be fully aware of what he/she is agreeing to when signing a loan guarantee.