What is a loan guarantor and how does it affect your credit score?

When applying for a personal loan, an individual must meet several eligibility criteria. Some of these include age, income, credit score, debt-to-income ratio (DTI), occupation, work experience, etc. What if the loan applicant’s income is lower or credit score is lower than the bank’s requirements for personal loans?

In such cases, hiring a loan guarantor can help them get the personal loan. In this article, we will understand what a loan guarantor is and how becoming one can affect your credit score.

What is a loan guarantee?

A loan guarantor is a person who promises to repay a borrower’s loan if the borrower cannot pay it. A guarantor increases the chances of approval for a personal loan, provided he or she has a good credit score, has an income to repay the loan, etc. For the bank, a guarantor is the borrower’s backup, in case the borrower cannot repay the loan.

Some people may find it difficult to get a loan because they may be new to lending or have a very short credit history. For people with a very short credit history, the bank may not be able to determine the repayment capacity of their loan. In such cases, the bank may ask the credit applicant for a guarantor to support his credit application.

A guarantor must sign a legally binding loan agreement. The agreement clearly states that if the borrower defaults, the guarantor must pay the outstanding principal, interest, and any penalties on the loan.

Factors to consider before guaranteeing loans

In the earlier section, we understood that the guarantor has a legal obligation to repay the loan if the borrower defaults. Some of the other factors to consider before becoming a guarantor include the following.

Reduction of the right to loans

When you guarantee a loan for someone, it reduces your eligibility for a loan. For example, suppose you qualify for a loan of Rs. 5 lakhs. You become guarantor of someone’s Rs. Personal loan of 2 lakhs. In such a scenario, your loan eligibility drops to Rs. 3 lakhs from the earlier Rs. 5 lakhs because you guarantee someone’s Rs. Personal loan of 2 lakhs.

While checking your credit report, the bank can see that you are a guarantor for someone’s loan. Until the loan is fully repaid, the bank considers the outstanding loan amount, for which you guarantee, as your debt. Before you guarantee a loan, you should therefore take into account that this will reduce your loan eligibility by the amount you guarantee.

The credit score is affected in case of default

If the borrower delays repayment of the loan or defaults, the bank will ask you as a guarantor to pay on behalf of the borrower. If you do not repay, the bank along with the borrower will report you as a defaulter to credit bureaus such as CIBIL. Loan defaults will be reflected in your credit report and your credit score will be affected. Moreover, as a guarantor, once the loan default is reflected in your credit report, you will find it difficult to get loans or credit cards from banks.

Legal action in case of default

If the borrower defaults and you as guarantor do not pay the loan, the bank can take legal action against you. The bank can follow the same legal procedure for recovering loans against the guarantor as in the case of the borrower.

A guarantor cannot easily terminate the loan contract

Once you guarantee a loan, it is not at all easy to terminate the loan contract. To terminate the loan agreement, the borrower must obtain another eligible guarantor. The bank must approve the other guarantor; only then can you terminate the loan contract. The approval process for the other guarantor may go through multiple approvers and can be time consuming.

Things to check before you guarantee

Before you decide to guarantee someone’s personal loan, check the following things.

Assess the borrower’s financial health

Check the career stability of the borrower, from the number of years he or she has already worked, the number of years with the current employer, etc. You can assess the financial health of the borrower by calculating the debt-to-income ratio (DTI).

The DTI ratio measures the percentage of monthly income that goes toward debt repayment. A DTI of 35% or lower is good. A DTI between 36% and 50% should be viewed with caution. A higher DTI coupled with regular monthly expenses will leave little free cash flow for EMI repayments.

Read the loan agreement carefully

You must read the loan agreement point by point. It contains details of the guarantor’s responsibilities and liabilities. Make sure you understand these points before you sign the dotted line. You can also ask a lawyer to review the agreement before signing it.

Keep track of the borrower’s EMI payments

Even after becoming a guarantor, you have to monitor the borrower’s timely EMI payments. Every now and then you need to check with the borrower if he is facing any problem in paying the EMI for a particular month. Keeping track of the borrower’s regular EMI payments will ensure that the loan is repaid on time.

Do you need to guarantee a loan?

Sometimes it happens that a family member, friend, colleague, resident of the association, etc. approaches you to guarantee his loan. While you may agree to be a guarantor with the good intention of helping them, you should be aware of the risks involved. If you have plans to take out a loan for yourself in the near future, keep in mind that being a guarantor will reduce your loan eligibility due to the borrower’s outstanding loan amount.

If the borrower defaults, you will have to pay the loan. The default will also reflect on your credit report and make it difficult for you to get a loan for yourself. If you do not pay, the bank may take legal action against you. Keep all the above points in mind, think about them carefully and decide accordingly whether you want to guarantee a loan.

Gopal Gidwani is a freelance personal finance content writer with over 15 years of experience. He can be reached at LinkedIn.