Think 100 times before becoming a guarantor for a loan from a friend or relative! One mistake and your CIBIL score will be ruined.

Under the pressure of friendship, kinship or social etiquette, people often sign as ‘Guarantor’ on the loan documents of someone they know without thinking. Most people have the misconception that becoming a guarantor is just a formality in which they are assuring the bank that they know the person. The reality of banking rules and Indian law is quite the opposite and extremely harsh. When you sign someone’s loan agreement as a guarantor, you not only become a witness but also take on the financial and legal responsibility of the entire loan. If your friend fails to repay the EMI for any reason, the bank’s first attack falls on your CIBIL score, your savings and your personal assets.

Legally, you are not just a ‘witness’ but a ‘co-borrower’

According to Section 128 of the Indian Contract Act, 1872, the liability of the guarantor is absolutely ‘co-extensive’ with that of the principal borrower. Its direct legal meaning is that from the moment the principal borrower defaults in paying his EMI, the bank holds the guarantor as legally responsible for the recovery of the entire loan as the borrower.

Banks and non-banking financial companies (NBFCs) have the full right to demand the entire outstanding amount directly from the guarantor without initiating any lengthy legal process against the principal borrower. As soon as you sign the loan papers, you have given a legal undertaking to the bank that if the borrower does not return the money, you will repay every penny.

Direct and deadly attack on CIBIL score and credit profile

The first and immediate disadvantage of becoming a loan guarantor is to your credit score (CIBIL Score). The loan you guarantee is linked directly to your own credit report in the systems of the credit information bureaus (such as TransUnion CIBIL, Experian, Equifax, CRIF High Mark).

• CIBIL downgrade due to bounced EMI: If your friend does not pay the EMI of any month for 30 days or 90 days, then the bank sends the report of that default to the credit bureau. Due to this, there is a huge drop of 50 to 100 points in your CIBIL score along with that of the main borrower, even if you have paid all your other personal loan or credit card bills on time.

• Blot of ‘defaulter’ or ‘write-off’: If that loan is not repaid for a long time and becomes a Non-Performing Asset (NPA), then a permanent tag of ‘Settled’, ‘Written Off’ or ‘Default’ gets placed on your credit report, which keeps your credit rating bad for the next 7 years.

Your own loan eligibility (Borrowing Capacity) gets blocked

Whenever you go to the bank in future to get a home loan, car loan, education loan for children’s higher education or a personal loan for any medical emergency, the bank will check your ‘Fixed Obligation to Income Ratio’ (FOIR).

Banks consider the total outstanding amount of the loan guaranteed by you as your ‘Contingent Liability’. Suppose your monthly income is ₹1 lakh and you have guaranteed your friend’s home loan of ₹30 lakh, the bank will consider that you already have a huge financial burden. As a result, the bank will either reject your own loan application outright, or drastically reduce the loan amount sanctioned to you and charge higher interest rates.

Calls from recovery agents, legal notices and threat of asset confiscation.

When a loan is declared NPA, banks are not limited to just phone calls. The entire aggressive machinery of recovery becomes active:

1. Mental pressure of recovery agents: The bank and its authorized recovery agencies start making inquiries at the home and office addresses of the guarantors, causing a severe blow to the social reputation.

2. SARFAESI Act and Law Cases: In case of secured loans (like home loan or mortgage loan), the bank can initiate the process of attaching the property under the SARFAESI Act, 2002 without going to court. In cases of unsecured personal or business loans, the bank can file a suit against the guarantor in the ‘Debt Recovery Tribunal’ (DRT) or civil court.

3. Risk of bank accounts and salary attachments: After the court order, the bank can freeze the savings accounts of the guarantor and make monthly deductions (Salary Attachment) from the job salary of the guarantor. If the guarantor has any immovable property, it may have to be auctioned to recover the loan.

If you are forced to become a guarantor, then keep these 5 precautions in mind

If it is unavoidable for a very close family member (such as a sibling or spouse) to act as guarantor, follow these strict rules instead of blindly signing the papers:

• Fair examination of the financial capacity of the borrower: Don’t just get into emotional things. Check whether the loan borrower has a stable source of income, his/her past CIBIL record and whether he/she is able to repay the EMI on time every month.

• Make loan protection/term insurance mandatory: Ask the main borrower to take a ‘Loan Term Insurance’ (Loan Cover Policy) equal to the loan amount. Due to this, in the unfortunate event of death or serious accident of the borrower, the insurance company repays the entire loan of the bank and there is no financial burden on the guarantor.

• Demand for quarterly statement: Ask for the bank’s ‘loan repayment statement’ from the borrower every three months so that you know whether the EMIs are being paid on time or whether there is any outstanding balance.

• Limited Guarantee Agreement: As far as possible, ask for a ‘Limited Liability Guarantee’ from the bank instead of ‘Unlimited Continuing Guarantee’, in which your legal liability is limited only to a certain amount or for a limited period.

• Provision for Loan Guarantor Replacement: If your financial situation changes in the future or you want to take a bigger loan yourself, then start the process of releasing yourself from that guarantee by talking to the bank and getting another co-applicant or another guarantor submitted on behalf of the main borrower.

How to politely refuse to be a guarantor?

It may be uncomfortable to say ‘no’ to someone in a friendship or relationship, but it is extremely important to overcome a moment’s hesitation to avoid future financial ruin and legal lawsuits. You can explain clearly and logically to the other person that you yourself are in the process of taking a big home loan or business loan in the near future and your CA/Financial Advisor has given strict instructions that becoming a guarantor in any other loan will void your own loan file.

The most basic rule of financial prudence is to never take on any debt for which you have not used the money yourself. Prudence and caution are the real protection of your hard-earned money and credit score.