When Mumbai-based Indresh Solanki, 48, a disciplined investor with no borrowing history, stood as a guarantor for a loan taken by his cousin’s son, Mayur, in 2016, little did he know that one day bankers would come knocking at his door to recover the dues. Mayur had taken an education loan and eventually defaulted three years later. “The bank was persistent in recovering the outstanding amount from me,” says Indresh. He, then, took the help of a lawyer to get out of the guarantor contract and liability.
It’s perfectly fine to lend a helping hand, but in these COVID-19 times, when banks have extended loan moratoriums, a guarantor’s liability can increase manifold if the borrower defaults later after taking the benefit.
What is the role of a loan guarantor?
Financial institutions ask for a guarantor when they are uncomfortable with the primary borrower’s financial situation and repayment capability. A guarantor is asked for not just to be a witness or someone who proves the authenticity of the borrower. Fundamentally, when a borrower is unable to make repayments in time, the liability falls upon the guarantor to make good the dues.
If you signed as a guarantor for someone, here is what you must know to protect yourself.
Deviation from the original agreement
Every loan agreement between a bank and borrower comes with terms and conditions. These include the rate of interest, payment terms and pre-payment liabilities. If any of these terms get altered during the course of the loan tenure, the guarantor’s liability goes away. Reason: the guarantor wasn’t involved in the negotiations between the bank and the borrower.
Shabnam P M, Vice President and Head-Legal, Federal Bank says, “In such a restructuring of a loan, the guarantor can claim that she was not aware of subsequent loan arrangement between the banker and the borrower; hence no responsibility arises.”
Opting for a moratorium is different though. Shreni Shetty, partner at ANB Legal says, “A borrower opting for loan moratorium will not be considered as a deviation from the loan agreement because it’s a relief announced by the Reserve Bank of India (RBI) to borrowers.”
However, the bank will inform the guarantor when the borrower opts for a loan moratorium as she is a part of the loan agreement.
If you are a loan guarantor, keep an eye on the repayments of the borrower. Zulfiquar Memon, Managing Partner, MZM Legal says, “In case a borrower has opted for a loan moratorium, then the guarantor should get a copy of the moratorium approval.”
Check for exit clauses in the agreement
Guarantors don’t have much say in negotiating with a bank for having exit clauses while entering into the agreement with the borrower and lender. “However, some loan agreements do have an exit clause for a guarantor,” says Mayank Mehta, Partner of Pioneer Legal. For instance, agreements can be worked out to limit the guarantor’s liability to 40 percent of loan repayment, in case the borrower defaults. It’s important to verify the loan agreement for any exit clauses.
“If you are relieved from the agreement as a guarantor, make sure you take that in writing from the bank with loan account details mentioned. So, in future, if the borrower defaults, the liability does not fall upon you,” says Sukanya Kumar, Founder and Director of home loan advisory firm, RetailLending.com.
Request lender to replace you as a guarantor
Replacing a guarantor during the term of a loan is possible. Requests for replacing a guarantor mainly arise if there are disputes between a borrower and the guarantor or the economy is slowing down leading to probability of rising loan defaults.
Says Kumar, “You should inform the borrower that you don’t wish to be a guarantor for the loan anymore and inform the bank as well.” The bank then approaches the borrower and requests for a new guarantor. The borrower has to arrange for a new guarantor. Until a replacement is found, you will have to continue as a guarantor as per the existing loan agreement. Kumar says, “Finding a new guarantor to replace you in these pandemic times will be a challenge for the borrower.” If, over a period of time, the borrower cannot produce another guarantor, the lender may ask you to repay the outstanding loan amount in case of defaults.
Have an indemnity agreement with the borrower
If you end up paying the borrower’s dues after she defaults, how will you recover your money? Memon says that a separate indemnity agreement should be signed between you and the borrower you are standing in for, to ensure she repays you the dues if she defaults and you had compensated the bank.
As a precautionary measure, you must enter into an indemnity agreement with the borrower. Memon explains that such agreements compel the borrower to pay you eventually. You can enter into an indemnity agreement even now if the loan was taken earlier.
He adds, “A guarantor cannot enter into an indemnity agreement after the borrower has already defaulted on repaying the loans. The agreement will be considered null and void.”
Similarly, an indemnity agreement entered into after the borrower opts for the moratorium may not stand the test in a court later because it could be proved that the borrower may have signed the indemnity under pressure.
Standing as a guarantor is not wrong. But make sure you know what you’re getting into. Reduction in income or, worse, a job loss in this pandemic can hurt anyone – a borrower or even a guarantor. It’s important to assess the repayment capacity of the person you are standing for as a guarantor. If the default probability is high, avoid standing in as a guarantor. If you still have to, make sure an indemnity agreement is signed and is water-tight.