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

While applying for a personal loan, an individual has to fulfil various eligibility criteria. Some of these include age, income, credit score, debt-to-income (DTI) ratio, profession, work experience, etc. What if the loan applicant’s income is lower or credit score is lower than the bank’s personal loan eligibility requirements? 

In such cases, bringing in 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 guarantor?

A loan guarantor is an individual who promises to repay a borrower’s loan if the borrower is unable to pay it. A guarantor increases the chances of personal loan approval provided they have a good credit score, income to repay the loan, etc. For the bank, a guarantor is a borrower’s backup, in case the borrower cannot repay the loan.

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

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

Factors to consider before becoming a loan guarantor

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

Reduction in loan eligibility

When you become a loan guarantor for someone, it reduces your loan eligibility. For example, assume you are eligible for a loan of Rs. 5 lakhs. You become a guarantor for someone’s Rs. 2 lakhs personal loan. In such a scenario, your loan eligibility reduces to Rs. 3 lakhs from the earlier Rs. 5 lakhs as you are a guarantor for someone’s Rs. 2 lakhs personal loan.

While checking your credit report, the bank can see you are a guarantor for someone’s loan. Till the loan is completely repaid, the bank treats the outstanding loan amount, for which you are a guarantor, as your liability. Hence, before becoming a loan guarantor, please bear in mind that it will reduce your loan eligibility by the amount for which you are a guarantor.

Credit score gets hit in the event of default

If the borrower delays or defaults on loan repayment, the bank will ask you as the guarantor to pay on the borrower’s behalf. If you don’t repay, the bank will report you, along with the borrower, as a defaulter to the credit bureaus like CIBIL. The loan default will reflect in your credit report, and your credit score will be hit. Also, as a guarantor, once the loan default reflects in your credit report, you will find it difficult to get any loans or credit cards from banks.

Legal action in the event of default

If the borrower defaults, and you, as a guarantor, don’t pay the loan, the bank can take legal action against you. The bank can follow the same legal process for loan recovery against the guarantor as in the case of the borrower.

A guarantor cannot easily exit the loan contract

Once you become a loan guarantor, it is not at all easy to exit the loan contract. For you to exit the loan contract, the borrower will have to get another eligible guarantor. The bank must approve the other guarantor; only then can you exit the loan contract. The approval process for the other guarantor may go through multiple approvers and may be time-consuming.

Things to check before becoming a guarantor

Before you decide to become a personal loan guarantor for someone, check the following things.

Assess the borrower’s financial health

Check the borrower’s career stability, from how many years they have been working, the number of years with the current employer, etc. You can assess the borrower’s financial health by calculating their debt-to-income (DTI) ratio. 

The DTI ratio measures the percentage of monthly income going towards debt repayment. A DTI of 35% or lower is good. A DTI between 36% to 50% should be looked upon with caution. A higher DTI along with regular monthly expenses will leave little free cash flow for EMI repayments.

Read the loan agreement carefully

You should go through the loan agreement point by point. It will have details about the guarantor’s responsibilities and liabilities. Make sure you understand these points before signing the dotted line. You may also ask a lawyer to check the agreement before you sign it.

Keep track of the borrower’s EMI payments

Even after becoming a guarantor, you should monitor the borrower’s timely EMI payments. Occasionally, you must check with the borrower if they are having any difficulty in paying the EMI for any month. Keeping track of the borrower’s regular EMI payments will ensure the loan is repaid on time.

Should you become a loan guarantor?

Sometimes, a family member, friend, colleague, society resident, etc., may approach you to become a guarantor for their loan. While you may agree to become a guarantor with the good intention of helping them, you should be aware of the risks that come along with it. If you have any plans to take a loan for yourself in the near future, remember that becoming a guarantor will reduce your overall loan eligibility to the effect of the borrower’s outstanding loan amount.

If the borrower defaults, you will have to pay the loan. The default will reflect in your credit report also and make it difficult for you to get a loan for yourself. If you don’t pay, the bank can take legal action against you. Keeping all the above points in mind, think about it thoroughly and accordingly decide whether you want to be a loan guarantor.

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