Have you ever been approached by a friend or relative who needed you to co-sign or guarantee a loan or their mortgage?

Do you know of what you are getting yourself into when you co-sign or guarantee a loan?

People often co-sign or guarantee loans for friends or relatives without understanding the implications If they knew, they might not co-sign or guarantee the loan. This article is going to explain:

*The difference between co-signing and guaranteeing a loan
*The different types of guarantees
*The legal result of co-signing or guaranteeing a loan

Difference between Co-Signing and Guaranteeing a Loan

If you guarantee a loan for someone who borrows money -the debtor, the lender must first demand payment from the debtor, before going after you, the guarantor. But, if you co-sign a loan, you are just as liable as the debtor is. So the lender can demand payment from you before, or even instead of, demanding payment from the debtor. It’s important that you review the guarantee or co-signing documents carefully before signing. These documents are often drafted so that there is little difference between the two. The result is that guaranteeing a loan often carries with it similar obligations and responsibilities as co-signing a loan.

Types of Guarantees

They include:

* Specific guarantee
* Continuing guarantee
* All accounts guarantee

Before you sign a guarantee, you should find out what type of guarantee you are signing. A guarantee document may contain one or more of these guarantee types:

Specific guarantee

A specific guarantee means you agree to pay or be liable for a certain amount for a specific thing. For example, you guarantee a car loan for a fixed amount of, say, 500,000 Ksh

Continuing guarantee

A continuing guarantee means you agree to pay a particular type of loan as long as the guarantee lasts. For example, you guarantee the operating line of credit for your spouse’s business. The line of credit may be at zero, or it may be at the maximum amount. It usually goes up and down with the cash-flow and profitability of the business. But you’re responsible for everything owing until the guarantee ends and the entire debt is paid.

All accounts guarantee

An all accounts guarantee means you agree to pay any amounts the debtor owes to the lender, including amounts that you may not know about. The loan agreement may let the debtor borrow more, and you’ll be liable for those amounts too. You’re also liable for things called “contingent liabilities,” such as the lender’s costs to collect the debt, which may include the full amount of any reasonable legal and other fees. Lending companies use this type of loan agreement most often.

What can happen if you co-sign a loan?

If your friend borrows money from a bank to buy a car and you co-sign their loan, things are fine as long as they make all their payments on time. But if they can't make a loan payment, the bank can take money from your bank account before you know anything about it.

What can happen if you guarantee a loan?

In this example, if you guarantee the loan instead of co-signing it, you may still have to pay the full amount. But in many cases, the bank has to first demand payment from your friend before getting it from you.

Pledge something for the loan?

Say your friend used (or pledged) the car he’s buying as security for his car loan, with a security agreement. If he can’t make a loan payment, the bank can seize the car. If the bank does that, you’re not responsible for anything more. The bank can’t sue after seizing the car, even if the car is worth less than the amount of the loan still owing. But if you pledged something as security for the loan, the bank can seize what you pledged, instead of going after your friend or seizing what they pledged.

Acceleration clauses

Most loan contracts have an acceleration clause. It lets the lender demand immediate payment of the whole loan, not just the “arrears” or missed payments, if the borrower breaks any part of the agreement. So just one missed payment could mean you have to pay the whole loan immediately.

Risk of future borrowing

A major risk if you co-sign or guarantee a loan is that you may be responsible for additional money that the debtor may borrow later. In standard loan forms, a clause makes you responsible for both the loan, and any other amounts the debtor borrows from the same lender in the future, plus the lender’s costs to collect the debt. This is true even though you may not know anything about the debtor borrowing more. So if you co-sign or guarantee a loan, put a ceiling or an upper limit in the loan contract to limit how much you could be responsible for.

Your credit rating could be affected

Even though the loan is made for the benefit of the person you are helping, if that debt goes into arrears, a negative entry may be added to your credit report. This is usually more of a concern if you are a co-signer, where you are jointly responsible for the debt – any default on the debt can have an immediate impact on your credit rating. With a guarantee, because the guarantor generally isn’t liable until repayment has been demanded, your credit rating may only be affected if you don’t repay the debt when demanded by the creditor.

Before you co-sign or guarantee a loan, read the document carefully

Sometimes it's necessary or helpful to co-sign or guarantee a loan. It may be a sound business deal, or it may help a family member. But before you agree to put yourself at risk, look at the situation carefully. Ask questions like:

* Why does the lender require a co-signer or guarantor?
* How high is the risk that the borrower will have trouble and you’ll have to pay the loan?
* What will happen if you don't sign?
* Most importantly, can you afford to pay off the loan if the borrower can’t?

If you’re not sure about your responsibility, or about anything else in the loan contract, get advice from a lawyer. If you decide to co-sign or guarantee a loan, ask the lender in writing to keep you informed in writing of all activity on the loan. This can help you see a problem developing and correct it before it’s too late. You should also insist on a copy of every document you sign.

What should you do when the loan is paid off?

If you guaranteed the loan, you want to be absolutely sure that you don’t remain liable on your guarantee after the original loan has been paid off. To protect yourself, insist on the lender returning the original guarantee to you after the loan has been repaid in full.