Understanding a loan guarantee agreement

Helping a family member or close friend obtain a mortgage or other loan, or getting a loan for your own business, may require you to personally guarantee the loan.

Before taking this risky step, be sure you understand what goes into a loan guarantee agreement.

Uses of loan guarantee agreements

A loan guarantee is a legally binding commitment to pay a debt in the event the borrower defaults. This most often occurs between family members, where the borrower can't obtain a loan because of a lack of income or down payment, or due to a poor credit rating. A guarantor also may be used to secure a better interest rate or other more favorable loan terms.

Common examples are when parents guarantee a mortgage so a child can buy a house, or guarantee a loan for a car purchase. A loan guarantee also may be used to help someone out of a financial bind. If someone is in default on an existing debt, and may be facing collection actions, it may be possible to revise the terms of the loan, or obtain a new loan, by offering a loan guarantee.

Another use of a loan guarantee is borrowing money to start or expand a business. You may have organized your business as a corporation or limited liability company (LLC) in order to take advantage of the limited personal liability it offers. If your company doesn't have sufficient assets for collateral, lenders may consider a loan to the business entity too risky. In this case, you may need to sign a loan agreement with a personal guarantee. As the guarantor, you are negating the personal liability protection of the corporation or LLC as to the loan, and are allowing the lender to go after your personal assets in the event of default.

Being the guarantor

Becoming the guarantor for a loan is a step that should not be taken lightly. Even if the borrower maintains payments, the guarantor may be prohibited from transferring assets or taking other financial actions without the consent of the lender.

Serious consequences can occur if the borrower defaults. In addition to being required to step in and make the payments, you may have to come up with additional funds to pay any amounts in default, and to pay attorney fees and other collection costs. This also can have an adverse effect on your credit rating. The borrower's default also could make the entire balance of the loan due immediately, rather than its being paid under the original terms.

Content of a loan guarantee agreement

The loan guarantee agreement usually will be created by the lender. Its exact terms will vary depending upon the lender, and upon state law. Most, if not all, of the terms of the agreement will be designed to protect the lender.

The agreement can create an absolute or unconditional guarantee, which obligates the guarantor for the debt if the borrower defaults for any reason. Or, the agreement can obligate the guarantor only if certain stated conditions occur. For example, it may require the lender to first pursue all legal collection remedies against the borrower before turning to the guarantor for payment.

The guarantee also may have other limitations. For example, if the loan is guaranteed because the borrower doesn't have the 10 percent down payment that is normally required, the guarantor may only have liability for that 10 percent. The agreement also may provide for the release of the guarantor's responsibility once a certain amount of equity has been reached.

In addition to the types of terms found in almost any contract, there are provisions that are unique to loan guarantee agreements, such as:

• Guaranty of payment and not of collection. A statement to this effect allows the lender to go after the guarantor immediately upon default by the borrower, without having to first seek collection from the borrower.
• Liability for attorney fees and other costs of collection against the borrower. This goes beyond making the guarantor liable for costs of pursuing collection from the guarantor.
• Waiving right to notice of default. Although one would think that a responsibility of the lender should be to promptly notify the guarantor in the event of default by the borrower, the loan guarantee agreements of most lenders specifically avoid this.
• Consent to modification of the loan. If the lender and borrower later modify the terms of the loan, it could relieve the guarantor of liability. This will depend upon state law, and whether the modification significantly increases the guarantor's risk. The lender may require the guarantor to sign a new guarantee agreement. To avoid this, the original agreement can provide that the guarantor consents to be bound by any modifications.

Whether the personal guarantee loan agreement must be witnessed or notarized will be determined by the lender's requirements, and possibly by state law. If the loan covers real estate, the agreement will most likely need to be witnessed and notarized in the same manner as required for a deed.

It is essential for a guarantor to read and understand the loan guarantee agreement. For help with preparing a loan guarantee agreement, you may want to consult with an attorney, to be sure that you are adequately protected in your role as guarantor of the loan.