Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Guaranteed Loan

What it is:

With a guaranteed loan, a party other than the borrower has promised to take responsibility if the borrower cannot make the payments. The entity assuming this responsibility is called the guarantor.
 

How it works (Example):

Let's assume Company XYZ would like to borrow $100,000 from a bank to buy a piece of equipment. Although the business will be responsible for the payments, it will probably require owner John Doe to provide a personal guarantee on the loan. By doing so, John Doe agrees to repay the loan using cash flows from other parts of his life and assets if Company XYZ is unable to generate enough cash on its own to repay the debt.

Guarantors don't always guarantee the entire amount of a liability. They might only guarantee the repayment of interest or principal, for example, but not both. Sometimes more than one entity might guarantee a loan; in these cases, each guarantor is usually only responsible for a pro rata portion of the debt, but in other cases, each guarantor may be responsible for the other guarantors' portions if they also default on their responsibilities.

Guarantees are common in the student loan industry, whereby the federal government guarantees loans to people who are generally young and without real credit history. This guarantee induces banks to lend to students and guarantees that the banks will be repaid.

Why it Matters:

Guarantees mitigate risk, but it is important to note that they do not make a loan risk-free. After all, it is still possible that even the guarantor can default on the liability if the liability is too large or if the guarantor is already struggling for other reasons. Regardless, guarantees provide an extra layer of security, which is why guaranteed bonds often get higher credit ratings.

Historically, if the guarantors are public companies, they disclosed the nature and size of their guarantees (often for loans their subsidiaries have borrowed) in the notes to their financial statements. But in 2002 the Financial Accounting Standards Board (FASB) issued Interpretation 45, stating that guarantors must book the fair value of the guaranteed loan as a liability on the balance sheet and that they must do so at the inception of the guarantee. Some guarantees, such as those that are accounted for as derivatives, those issued by insurance companies, and some guarantees issued by leasing companies, are exempt from this rule. It is important to note that guarantees issued between parents and their subsidiaries do not have to be booked as balance sheet liabilities.

All guarantees must, however, be disclosed. The guarantor must disclose the nature of the guarantee (terms, history and events that would put the guarantor on the hook), the maximum potential liability under the guarantee, and any provisions that might enable the guarantor to recover any money paid out under the guarantee.