Signing up as Loan Guarantor? Beware of Risks

Your close friend has been planning to buy a house for a long time. However, when he approached the bank to apply for a home loan, bank insisted to getting someone to sign as a guarantor for the loan. Lenders can ask for a financial guarantor if the credit history is weak or repayment ability of the applicant is in doubt. The friend requests you to sign up as a guarantor for his home loan. What do you do? You mind says No but you do not want to put your friendship on stake for this PETTY money matter. What will you do? The bad part is there is no middle path. Either you have to say Yes or you have to say No. The choice is yours but you must consider the following aspects if you were to sign up as a guarantor for a loan.

#1 In case of default, the bank will come after you. There is no provision that the bank has to exhaust all the options to recover money from the borrower. The bank can directly approach you. If the borrower does not pay, YOU have to pay. After all, the bank has lent taking comfort from your financial position. Therefore, you also need to make an assessment if your friend can repay the loan. In this case, a few subjective parameters such as how responsible your friend is, his skill sets, his earning prowess come into picture. You need to draw upon your experience to make this judgment. You also need to see if you will be in a position to repay the loan if your friend or relative were to default.

#2 Your loan eligibility will take a hit. The loan guarantee counts against your loan eligibility. Therefore, if you act as guarantor for a loan, your loan eligibility will go down. If you are not planning to take another loan in your life, this aspect should not be a problem. However, if you are planning to take a home loan yourself, think twice before signing up as a guarantor. Do note a home loan is a long term commitment. Moreover, under reducing balance method, the outstanding loan goes down very slowly during the initial years. In a way, your loan eligibility will take a hit for many years.

#3 Your Credit Score is at stake. Since even a guarantee counts as your liability, any defaults on the loan will affect your credit score adversely. It does not have to a full fledged default. Even irregular/delayed payments by the borrower can affect your credit score. With a poor credit score, your chances of taking a loan or a credit card may get adversely affected. We discussed in an earlier post how lenders may start linking loan interest rates to your credit score. It does not end here. Your credit score can play a role even in areas remotely related to borrowing. What if you have furnish your credit score when you apply for a club membership? What if employers start asking for credit score along with job applications? You never know.

#4 Let emotions take a backseat.  If you feel that the friend or relative is not that responsible or is likely to struggle with payments, say No to a request to sign up as a guarantor. Make a rational choice. You do not want to mess up your financial life just because somebody else cannot repay the loan. There is nothing to be defensive about. Instead, offer help in improving credit history or finding a better paying job. For all the stupid things that bankers do, they do one thing right. Such are the bank processes that they do not work on trust. Banks do not work on emotions.  So should you in this case. Easier said than done.

#5 Ensure that your friend or relative has adequate life insurance.  What should you do if you have to or have already signed up as a guarantor for the loan? You need to mitigate risk of non-payment of loan. Your friend or relative may be the most responsible person on earth. However, he can repay loan only so long he is alive. If something were to happen to him, the bank will again come after you to settle the loan. 

Banks take care of this part by persuading borrowers to purchase a home loan protection plan (HLPP). If you think an HLPP will take care of this issue, you are quite far from the truth. Consider this exampleTherefore, you CANNOT rely on banks to help him purchase the right cover. Banks sell all kinds of insipid insurance plans. ICICI Home Loan Safe Plus is a classic example where only accidental death is covered or only critical illness is covered. Perhaps, smart executives at ICICI Bank and ICICI Lombard think that the borrower cannot die of a natural illness. Even consumer courts have taken exception at such poor products. Bank has property as security. Bank has guarantor in you. Bank has earned hefty commissions selling your friend a poor insurance product. Bank has everything covered. What about you?

The least you can do is to urge your friend to purchase the right life insurance plan and follow up on timely renewals. I know it is easier said than done but you do not have any other option. In fact, your friend or relative should have adequate health cover and disability cover too. You need to advise your friend on ring-fencing his finances. A health cover helps him avoid financial trouble in the event of medical emergency in the family. A disability cover may help overcome short term loss of income due to temporary disability. Additionally, if the earning potential is compromised due to a permanent disability, proceeds from such a plan can help square off the loan.

Leave a Reply