Why it's risky to become a guarantor

Everyone wants to do the good deed of becoming a guarantor - it's like helping an old friend or family member in the time of need. But it can backfire, if things don't work out as you planned.

Here is an example: An old friend recently asked me, "What if I become a guarantor for my nephew's home loan?  Are there any adverse implications for me?

There could be is the simple answer. While there is no clear reply to the question because there are a number of factors that a potential guarantor has to consider, the thumb rule is that one has to carefully look at his and the borrower's financial position before taking this big step.

So why do banks seek guarantors at all? It's because it gives them an assurance that there is someone else, who is sharing the loan burden with them, in case of a default.

There are several categories of people who need to have a guarantor. For instance, a businessman with uncertain inflow or a salaried who is liable to be transferred constantly or a buyer from another city or country has to have someone who takes responsibility of the loan.

By seeking a guarantor, the lender tries to enforce a moral check on the borrower. Of course, if an applicant feels that he is unable to secure a loan on his own, he can take the initiative himself as this would improve his creditworthiness.

But a guarantor needs to be cautious - For one, it is necessary to assess the borrower's credit and cash flows, to determine if he or she is capable of handling the loan. Since a guarantor is liable to pay in case the original borrower misses on repayments to the lender, he needs to take such a step.

Importantly, do not agree to be a guarantor if you are not confident. Make certain you have a copy of the loan contract and that you read and fully understand it before signing. Check the numbers, because there is no way to back out once one has to enter into a deed of guarantee where he/she agrees to make the payment.

You cannot revoke your guarantee after the loan has been sanctioned. So, before you do sign the dotted line, check whether the contract tells you the amount you are guaranteeing, the situations in which you will have to repay the loan and if the amount to be borrowed can be increased without you being told.

And at risk are the guarantor's personal assets like bank accounts, cash and property, which could be attached leading to unwanted financial stress. However, provident fund and agricultural land cannot be attached under any court decree.

Obviously, getting entangled in such a case could hurt the guarantor's creditworthiness as well. This could reduce his ability to raise a loan or cash in the future. When you apply for a loan, most banks would want to know if you have stood as a guarantor for any other loan.

And the bigger the amount that has been guaranteed, the lower is the creditworthiness. In fact, in some case when the guarantor needs a loan, he/she may have to one for himself/herself as well.

Banks deduct that amount from your loan eligibility. Also, if the borrower has defaulted on some payments during the course of the loan, this also shows up on the guarantor's credit history. This may additionally reduce your chances of getting a loan.

Recently, the Supreme Court has reiterated through a decision that a guarantor cannot back out of the loan commitment. As the guarantor is the security provider for repayment in case of default, legal action can be taken against the guarantor.

In other words, it is good to help someone. But, only if you have the ability to take the financial hit, if required.