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What Is a Financial Guarantee?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 04 July 2014
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    2003-2014
    Conjecture Corporation
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A financial guarantee is a contract that helps to ensure that a creditor or lender is reimbursed for any losses that result from the failure of a debtor to make payments on the outstanding debt in accordance with the provisions of the agreement that governs the business relationship. This type of guarantee is often in the form of an indemnity bond that cannot be canceled until the debt is repaid in full. Many insurance companies offer financial guarantees as tool to help decrease the risk to any individual or institution that functions as a debt issuer.

One of the benefits of the financial guarantee is that it can help the debtor to secure a more attractive interest rate on the loan or other debt instrument. This is because the guarantee helps to lower the degree of risk that the lender is taking on in order to approve the loan. Since the lender is covered in the event that the debtor becomes unable to make payments on time, there are no worries about out of pocket expenses associated with collections efforts or the loss of any amount remaining due on the debt instrument.

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This same benefit is also to the advantage of the debtor, since the lower interest rate means there is a smaller debt to repay over the long-term. The lower interest rate makes it possible to retire the debt sooner rather than later. Assuming that the debt is retired according to the terms of the lending agreement, the lender reports positive data that is reflected on the debtor’s credit report, and thus increases his or her credit rating.

Many types of securities are issued with a financial guarantee in place. Bonds are one of the more common examples of investments that carry this type of coverage. In the event that the bond issuer is unable to repay the initial investment plus any interest income due to the bond holder, the insurance provider that underwrote the bond with the aid of a financial guarantee issues payment to the holder. As a result, the investor does not experience any type of loss and is free to use the funds paid by the insurer for any purpose he or she desires.

Depending on how the financial guarantee is written, the insurer may have the option of paying off the amount due in one lump sum, or by making a series of payments. When multiple payments are issued, there are usually some guidelines that specify how long the insurer can take to completely settle the debt. For example, the terms may allow the outstanding amount to be settled with a series of monthly payments, with the settlement taking no longer than twelve consecutive months.

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