A guaranteed loan is a loan that is guaranteed by a third party in case the borrower defaults on a loan. In a guaranteed loan, a party has promised to take responsibility on behalf of the borrower in case he or she fails to repay the loan. This entity taking up the responsibility is referred to as the guarantor.
A guarantor is an entity that co-signs the loan agreement and withholds the obligation of repaying the loan defaulted by the borrower. The guarantor may be a government agency, which will then buy out the debt from the lender and become responsible for the loan.
One common example is a payday loan. In a payday loan, the borrower’s paycheck plays the role of a third party that guarantees the loan. In most cases, a guaranteed loan is taken by a borrower when he or she is not an ideal candidate for a regular bank loan. People in dire need of financial assistance resort to a guaranteed loan as it does not put a lot of risk on the lending institution and is relatively easier to get as compared to a regular loan.
Repayment of the entire amount is not necessarily granted by all guarantors. Some may opt to repay only the interest amount or principal amount of the loan. In addition, in some cases, there is more than one guarantor. In such cases, each guarantor is liable only for a pro-rata portion of the debt, or, in some cases, each entity is responsible for all the other guarantor entities in case they too default on their payments.
Guaranteed loans decrease the risk factor; however, they are not completely risk-free as sometimes a guarantor may default on his responsibilities for various reasons. The entire agreement between the guarantor and borrower must be disclosed and well documented to prevent fraudulent cases in the future due to discrepancies. Student loans and startup business loans are the most prevalent examples of guaranteed loans.
If you secure a loan for your business and you sign a personal guarantee, you then become liable to repay the loan using your own assets if the business fails to pay.
Advantages of a guaranteed loan.
- It enables innovative startups to access loan capital because they reduce the risk to the lender.
- Loan guarantees bridge the gap between funding during a start-up phase and regular loans granted to SMEs
- It is a form of non-dilutive funding and has no effect on the ownership structure
- Low rates of interest are possible as compared to conventional loans
- No need to make upfront payments
- A guaranteed assistance for borrowers with a bad credit score
Guaranteed loan schemes have gained mass popularity in both high- as well as low-income countries. Their objective is mainly to enable entities to get loans from lending institutions, which would otherwise not accept them as loan clients. However, not everyone is in favor of loan guarantee schemes as this form of financial system also brings with various market imperfections.
