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Loan guarantees are promises by a third party that a loan will be paid in full, even if the original borrower defaults. The third party may be an individual, a business, or even a government entity. The purpose of the loan guarantee is to assure that the lender can extend loans, even in periods where economic conditions are not favorable for all types of borrowers.
With a personal loan, the loan guarantee often comes in the form of having a co-signer on the loan application. By choosing to co-sign with the debtor, the third party is making a commitment to the bank or other lender to take up payments or otherwise settle the outstanding balance of the loan in the event that the debtor is unable to do so. For example, if the debtor experiences a prolonged illness and cannot work, the co-signer may choose to take over the loan and make payments until the debtor is able to return to work and generate income once more. Should the debtor fall into arrears on the loan, the lender will contact the co-signer and request that at least enough payments be made to bring the loan current.
A loan guarantee sometimes involves the pledge of a business to pay off the balance of the loan in the event that the debtor is not able to do so. One example of this type of arrangement involves a subsidiary and a parent company. The subsidiary obtains a loan from a local banking institution, with the provision that the parent company will guarantee the amount of the loan, and settle the debt in the event that the subsidiary is sold, or is closed by the parent. This approach ensures the lender of being repaid in full under any circumstances, since the degree of risk involved is greatly reduced.
Governments sometimes operate programs that involve issuing a loan guarantee on specified types of loans. Mortgages are an excellent example of this type of lending situation. Provided that the mortgage is one that is approved by the government for coverage, the lender can rest assured that the loan will be repaid, regardless of any changes in the circumstances of the borrower. This type of arrangement will often allow lenders to work with applicants that fall into a higher risk category, and still extend reasonable rates of interest and other terms to those clients.
Along with protecting the interests of the lender, a loan guarantee can also provide several benefits to borrowers. When the loan is guaranteed, the lender is assuming less risk, and will often extend interest rates that would not be possible to obtain otherwise. In addition, programs of this type also allow borrowers who would never qualify for mortgages on their own to become home owners, something that often results in providing that individual with a more solid financial base over time.