I have recently been involved in the process of refinancing a family farm. After speaking with several banks, our family LLC settled upon our perceived best bank fit to provide the needed funding.
In the application stage, the bank requested that all the owners guarantee the loan. The bank claimed this is their standard practice until there is a history of gross revenues in the $4 to $5 million range — our small family farm’s revenue is orders of magnitude smaller. Not all banks operate this way, but financing options are limited in a small farming community in a sparsely populated state. So rather than seeking alternatives that would likely yield the exact same requirement, I decided to educate myself on what it means to guarantee a loan.
With seeding from Bard and chatGPT, I prepared the following primer on what it means to guarantee a loan.
As a loan guarantor, you agree to be responsible for the loan if the borrower defaults on their payments. In our case, the borrower is a family-owned LLC. If the LLC cannot pay the loan payments or otherwise defaults on the loan, the lender may come to you to pay the missed payment or possibly the outstanding loan amount.
Each person guarantees the outstanding principal amount rather than a pro-rata or other determined fraction of the loan.
The consequences of being a guarantor can vary depending on the loan agreement and the specific circumstances, but here are some potential future effects:
Financial Obligation: The primary consequence of being a guarantor is that you are legally obligated to repay the loan if the borrower defaults. So, if the borrower cannot make payments, you will be responsible for repaying the loan in full. If you do not repay the loan, it could negatively impact your credit score, and you may be subject to legal action by the lender.
Affect your Credit Score: Being a guarantor could affect your credit score. If the borrower defaults on the loan and you cannot repay it, it could negatively impact your credit score. If the borrower misses a payment, it will appear on both the borrower’s and the guarantor’s credit reports.
Difficulty Obtaining Future Credit: Being a guarantor could make it more difficult for you to obtain credit in the future. When you apply for credit, lenders will check your credit report and see that you are a guarantor for a loan. The Guarantee could make them hesitant to lend to you because they may see you as a higher-risk borrower.
Legal Action: If the borrower defaults on the loan and you cannot repay it, the lender may take legal action against you to recover the debt. This legal action could result in a court judgment against you, which could negatively impact your credit score and make it even more difficult to obtain credit in the future.
In practice, guaranteeing and co-signing a loan are used interchangeably but have differences. Guaranteeing or co-signing a loan tells the lender that you will be responsible for paying the loan if the primary borrower cannot or does not make payments. Either guaranteeing or co-signing means that if the borrower defaults, the lender can come after you for the outstanding balance.
The critical difference between the two is that a co-signer is typically a joint applicant for the loan, might have access to the loan proceeds, and has equal responsibility for making payments. In slight contrast, a guarantor may not have any rights to the loan proceeds and is only responsible for paying the loan in the event of default. Regardless of the terminology, it’s essential to understand the risks and responsibilities involved before agreeing to take on this kind of financial obligation.
Many websites provide reliable information on the risks of guaranteeing a loan. Some of the most reliable sources include:
Federal Trade Commission (FTC) – The FTC is a government agency that provides information on various topics, including consumer protection and finance. They offer information on co-signing loans and the risks involved.
Consumer Financial Protection Bureau (CFPB) – The CFPB is another government agency providing consumer financial protection information. They have resources on co-signing and co-borrowing, as well as the risks and responsibilities involved.
Bankrate – Bankrate is a financial website that offers a range of resources on loans, credit, and personal finance. They have articles on co-signing and co-borrowing that provide information on the risks involved.
NerdWallet – NerdWallet is another financial website that offers resources on loans and credit. They have articles on co-signing that explain the risks and alternatives.
The Balance – The Balance is a personal finance website that provides information on various topics, including loans and credit. They have articles on co-signing that explain the risks and responsibilities involved.
While these websites provide reliable information, consulting with a financial advisor or attorney before guaranteeing a loan is always a good idea. Overall, being a loan guarantor can have significant economic and credit consequences. It is essential to carefully consider the risks before agreeing to be a guarantor and to make sure you fully understand the terms of the loan agreement. The Guarantee signed with the loan provider will define the specific terms.
In practice, in the event of a borrower default, the bank will generally go after a single or ‘best’ subset of guarantors with the highest probability of paying back the loan while minimizing collection costs to the bank. The bank’s actions may leave the unfortunate situation where one or a few guarantors that have repaid the loan from personal assets may need to collect those amounts from either the LLC or other guarantors. ☹️
Why should you agree to guarantee a loan?
There are a few reasons why you might agree to guarantee a loan.
- To help out a friend or family member. If you have a close relationship with the borrower, you can guarantee their loan as a way of helping them out. Your Guarantee could be significant if the borrower struggles to qualify for a loan independently.
- To improve the terms of the loan. Sometimes, a lender may be willing to offer a better interest rate or other more favorable terms if the loan is guaranteed. More favorable terms are because the lender has less risk of losing money if the borrower defaults.
- To secure a business deal. If you are involved in a business deal, the other party may require you to guarantee the loan. In this case, the Guarantee might be because the lender wants to ensure the deal goes through even if one of the parties defaults.
It is essential to weigh the pros and cons carefully before agreeing to guarantee a loan. If you decide to guarantee a loan, ensure that you understand the terms of the agreement and are prepared to repay the loan if the borrower defaults.
Here are some things to consider before agreeing to guarantee a loan:
- Your financial situation. Can you afford to repay the loan if the borrower defaults?
- Your relationship with the borrower. Are you confident that the borrower will be able to repay the loan?
- The terms of the loan. Ensure you understand the interest rate, repayment terms, and other loan terms.
- Your legal rights. Get legal advice to understand your rights and responsibilities if you guarantee a loan.
Ultimately, the decision of whether or not to guarantee a loan is a personal one. There is no right or wrong answer, and the best decision for you will depend on your individual circumstances.
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