The role of guarantees in funding a business
There are various business funding options that require the borrower to have guarantees in place. This involves a third-party agreeing to pay any missed repayments that the main beneficiary does not make.
This is a common clause added to a contractual agreement as a way of lenders protecting themselves from any risks of default. Any additional guarantors are required to sign the loan contract for it to be accepted and in return, they may receive a small percentage of profits or the feeling that they helped a loyal colleague or friend. Many guarantors trust the main borrower to such a degree, that any potential risk is not applicable in their minds.
Guarantees exist in two forms:
- A pure guarantee ensures that the third party meets their financial obligations. They are legally obliged and responsible to be a guarantor.
- A conditional payment guarantee means that they are liable to pay any amounts outstanding.
When are guarantees used?
The use of guarantees offers extra security to the lender or business who is providing the finance. For an SME with only one director in the company, the lender relies heavily on their ability to pay it back. But with another person or company to back up the loan agreement, there is extra security that the lender will be able to recover their funds.
In particular, for those companies or directors with an adverse credit record, they may rely on the use of a guarantor in order to secure the funds they need. Every extra guarantee added gives the lender more confidence, especially when guaranteed by individuals or firms with strong credit records and reputations.
How can individuals use guarantees for business finance?
There is the business case that an individual may be better to apply for a loan, rather than the business. In some case, individuals may have better credit ratings and access to finance than small businesses. Instead of business funding, there is the consumer credit option and for directors to pay money into their business and receive dividends – becoming a cash business in the process.
Those with good credit scores can apply for personal loans up to £50,000 at 15.8% APR per year. However, those with less than average credit scores can use guarantor loans to borrow up to £15,000 over 7 years at around 39.9% to 49.9%. (Source)
The consumer guarantor lending sector is worth around £400 million in the UK and the default rate is less than 5%. Those that have guarantees from an individual with a homeowner status significantly increase their chances of approval. Lenders consider that those with a home should be easier to contact if they need to retrieve funds and be more likely to access finance if they ever needed to make a large repayment by potentially remortgaging or selling their house.
