Risks of becoming a loan guarantor and what to do in case of loan repayment default
The widespread salary cuts, job losses and general slowdown in the economy has also heightened the risk of loan defaults. To prevent a large number of defaults, the RBI directed banks and other lenders to offer a three-month moratorium and then extended it by another three months till August.
Experts feel this will defer but not completely avoid the problem of default. Loan defaults are bad news for people who have stood as guarantors to loans taken by friends and relatives. Banks usually don’t insist on guarantors for all loans, but they do when the collateral is not sufficient or when they doubt the repayment ability of the borrower. A guarantor is a must for big-ticket education loans and loans taken by retired persons.
Think before you jump in
A borrower usually taps a family member or a close friend to become a guarantor. If someone approaches you, the first thing to do is assess his repayment capacity. “A guarantor should probe the borrower like a bank and stand guarantee only when he is sure that the person is sincere and has the willingness and ability to pay,” says D.N. Panigrahi, Professor of Banking & Finance, Goa Institute of Management.
If adequate precautions are not taken, loan guaranteeing can turn into a nightmare. “Most people stand as a guarantor to avoid losing a good relationship. But they often end up losing money and also the relationship,” says C.S. Sudheer, CEO and Founder, IndianMoney. com.
Understand the risks involved
Most people know that a guarantor is liable to pay if the borrower defaults on the loan repayment. However, there are other risks that the guarantor is exposed to.
Standing guarantee for someone else’s loans will impact your own loan eligibility. There is no difference between the borrower and guarantor in terms of liability. The only difference will be in terms of cash flows. “Banks consider guaranteed loans as contingent liabilities. They are seen as part of a person’s total liability and his eligibility for credit will be reduced by the outstanding amount in the guaranteed loan,” says Gaurav Aggarwal, Director & Head of Unsecured Loans, Paisabazaar.com. One should keep in mind one’s future loan requirements before becoming a guarantor.
Default by the borrower will also impact the credit score of the guarantor. The guarantor details also get reported to the credit bureaus and borrowers and guarantors are treated as equals in case of defaults. This applies even to irregular EMI payments by the borrower. “Banks may not inform the guarantor in case of irregular EMI payments by the borrower. However, this will impact the credit score of the guarantor and he may not easily get a loan in the future,” says Adhil Shetty, CEO, BankBazaar.
The guarantor’s liability is not restricted to only the borrowed amount. The Indian Contract Act uses the word ‘surety’ for guarantor and Section 128 of Indian Contract Act very clearly states that “the liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract”. This means the guarantor will not only be liable for the principal loan amount, but also for any interest and charges which may have become due on the loan.
Most guarantors assume that banks will proceed against them only after exhausting all options available against the borrower. However, banks have the legal right to proceed against the guarantor before proceeding to the borrower. “If banks feel that chasing the borrower is difficult, it may resort to the easy way of targeting the guarantor. Banks usually resort to attaching the assets they have easy access, like money lying in savings or fixed deposit account with the same bank,” says Panigrahi.
What to do now
If you are already a guarantor, you need to be alert. “Keep in touch with the borrower informally on a regular basis and make sure that the loan repayment is happening smoothly. If the situation is bad due to the current conditions, counsel him how to go about it,” says Shetty of BankBazaar. You could also check with the lending bank. Besides this, check your own credit score on a regular basis. If anything is amiss, it will reflect in your score. Checking the credit score frequently will not have any impact on your creditworthiness. “Credit score goes down only in case a financial institution checks with the bureau after you apply for a loan. Checking your own credit score will not result in fall in credit score,” says Sudheer.
Most defaults are not intentional and happen due to circumstances. One can only take precautions against such eventualities. “The guarantor should insist that the primary borrower and co-borrowers take adequate loan protection insurance plans to mitigate his own liability in case of demise or disability of the borrowers,” says Aggarwal of Paisabazaar.
How to get out
There may be several reasons why you need to withdraw from the liability of a guarantor.
One reason could be the need to take a loan yourself. However, a bank may not allow a guarantor to withdraw from the role unless the borrower gets another guarantor or brings in additional collateral. Even if you get another guarantor, the bank has the discretion to disallow the switch.
What to do in case of defaults
If the borrower is not paying regularly, your best bet is to put social, peer and family pressure on him. If he doesn’t comply, you can show him the rulebook.
“According to the rule of subrogation under the Indian Contract Act, the guarantor has the right to recover the money later from the borrower,” says Panigrahi. Subrogation means stepping into the shoes of someone else (in this case, the guarantor becomes the lender).