A guarantee is a legal promise made by a third party (guarantor) to cover a borrower’s debt or other types of liability in case of the borrower’s default. Loans guaranteed by a third party are called guaranteed loans.
The guarantee can be limited or unlimited. An unlimited guarantee implies that the guarantor will cover the full amount of liability, while in a limited guarantee, the guarantor will cover only a portion of the liability.
Advantages of Guarantees
A guarantee serves as additional protection in a loan, making a loan more attractive to potential lenders. The lenders are more willing to provide guaranteed loans even to candidates with a poor credit profile, as the presence of a guarantor diminishes the probability of a lender of not being repaid.
A guaranteed loan is a viable option for borrowers with poor or no credit history. In such a case, the guarantor’s promise may allow borrowers to obtain loans that would otherwise be inaccessible.
Guarantees take several forms. The most common types include the following:
1. Personal guarantee
A personal guarantee is a promise to repay liabilities that is made by an individual on behalf of another individual or organization. A company’s executive or founder may become a personal guarantor to his or her company to be eligible to obtain a loan.
In making a personal guarantee, an individual promises to repay the outstanding loan amount in case of the borrower’s default or pledges his or her own assets, which can be used to repay the loan to the lender.
2. Bank guarantee
A bank guarantee is a promise from a bank to cover the liabilities of a debtor in case of the debtor’s failure to fulfill contractual obligations with another party. It is usually provided by commercial banks to companies involved in transactions with unfamiliar parties or foreigners.
3. Financial guarantee
A financial guarantee can be regarded as a form of a bank guarantee. Essentially, it is an obligation of a specialized insurance company to repay the remaining interest payments and the principal amount of a bond or similar financial instrument to the lender in case of the borrower’s default. Note that the financial guarantee can be used in transactions that involve various financial instruments and structured products.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: