Bankruptcy and the Personal Guarantee

Ever since the 2008 housing crisis, obtaining a personal loan is more complicated than it used to be—primarily because financial institutions have tightened their lending criteria. To improve the odds of getting a loan, you could ask someone to be a guarantor (an individual or company that pays an obligation if the borrower fails to do so). Or, if you're applying for a business loan, you might agree to guarantee the loan with your personal assets. If the personal guarantee comes due, and the guarantor doesn't have the funds to pay it off, in some cases the guarantee can be wiped out (discharged) in bankruptcy.

What Happens When the Borrower Defaults on a Guaranteed Loan?

If you default on your loan (usually by missing a payment), the lender has the right to ask the guarantor to take up the payments or to pay off the loan. At that point, the guarantor is subject to the same collection activities you would face under state law: telephone calls, letter demands, lawsuits, and even garnishment and property seizures.

Just because the bank turns to the guarantor doesn't mean that you will be off the hook, however. The lender can pursue you until the loan is paid in full (or you discharge it in bankruptcy). Also, if the guarantor pays the debt, the guarantor can also seek reimbursement from you. However, filing for bankruptcy will likely cut off the guarantor's right to recover against you, as well.

Who Can Be a Guarantor?

Just about any willing person can agree to guaranty a loan taken out by someone else. In reality, most of the time when the borrower is an individual and the money is for personal or educational purposes, the guarantor is a parent, another relative, or a good friend.

Additionally, creditors often require someone to personally guarantee a loan taken out by a business (primarily because of the frequency in which small businesses fail). The guarantor will have to submit to a credit check at least as rigorous as the borrower's, have sufficient income and resources to pay the loan back if that becomes necessary.

In some institutional lending programs, like student loans and small business loans, banks and other financial institutions make the loans, but the guarantor is the federal or state government. If you default, the government agency pays off the bank and takes ownership of the loan. You will then have to deal with the government agency to rehabilitate the loan or to pay it off.

Even with a government guaranty, the lender can still request that you supply a person to provide additional surety. When the borrower is a small business, the lender will routinely expect the owners or principals of the business to personally guarantee the business loan. Doing so offers the bank and the institutional guarantor added security in the event the company falters. In fact, when the loan is guaranteed by the Small Business Administration, anyone with an ownership interest of 20% or more must personally guarantee the loan. In some cases, the lender might ask spouses of guarantors to sign also to ensure that the parties most affected are aware of their responsibilities and of the consequences they could face.

Effect of a Guaranty on a Loan

Obtaining a guarantor can save a borrower money because banks sometimes will reduce the interest rate on guaranteed loans if it lowers the bank's risk of loss. It's not always the case, though. Lenders often ask for guarantors when the original borrower has credit issues, which may mitigate in favor of a higher interest rate. Some financial institutions will let you borrow more if you have a guarantor. For mortgages, the lender might let you finance 90% of the value of the house or make a smaller down payment.

Considerations for the Guarantor

If you're considering whether to guarantee a loan, you might want to answer these questions before you sign on the dotted line:

• Will agreeing to be a guarantor affect my credit score?
• If the bank forecloses on the borrower's property, will it appear on my credit report?
• Why is the bank requiring a guarantor?
• Do I have the resources to pay the entire loan back, if necessary?
• If the borrower is a good friend or relative, am I prepared to suffer the friction that could result if the borrower can't make payments?

Can a Guarantor Wipe Out a Guarantee in Bankruptcy?

In many cases, yes (but not all—for example, a guarantee for an educational loan won't go away unless you can show undue hardship). In fact, it's a common reason that people file for bankruptcy.

For instance, suppose that you took out a business loan to pursue your lifelong dream of opening a cupcake bakery. Because your business was new, the bank asked you to execute a personal guarantee. By signing the guarantee, you agreed to use your personal assets to pay off the loan if the business was unable to do so. If the cupcake business dried up and the bakery closed, you'd likely be able to wipe out the guarantee in Chapter 7 or Chapter 13 bankruptcy.