What are Guaranteed Loans?

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A guaranteed loan is a type of financing program that is backed by a promise (“guarantee”) from a third party to cover all or a portion of the lender’s losses should the official borrower fail to meet the loan’s repayment obligations. By so doing, the guarantor (third-party making the guarantee) is helping to lower the lender’s risk exposure.

A guaranteed loan should not be confused with a guaranteed-issue loan, in which a loan applicant is assured of a loan approval, regardless of credit history.

Types of guaranteed loans

Most guaranteed loans are characterized by government-backed programs such as certain mortgage loans and Small Business Administration, or SBA loans. Guaranteed loans can also have private guarantees from any other responsible third party willing to repay a loan on the borrower’s behalf should the loan go into default.

In fact, the co-signed loan may be considered one of the most common types of guaranteed loans. When a co-signer is added to the loan’s promissory note, that co-signer is essentially providing a guarantee for that loan. For example, some private student loans may require a parent to co-sign on a student’s loan. The parent provides a personal guarantee that he or she (or they) will be obligated to repay the loan, should their child fail to make loan payments.

The most common type of guaranteed loan in the US today is the home mortgage loan. In one way or another, the loan programs listed below receive some type of loan guarantee from the federal government:

  • Veterans Administration (VA) loans
  • Federal Housing Administration (FHA) loans
  • Farm and rural mortgage loans backed by the Department of Agriculture
  • Conventional loans backed by Fannie Mae and Freddie Mac

By providing guarantees, either explicit or implicit, the federal government lowers the risk exposure for banks, credit unions and lenders extending these loans. The federal government has good reason to offer these guarantees, which are essentially a form of subsidy:

  • Encourage lending. The primary reason is that lowering the risks encourages financial institutions to lend money. The guarantees will not prevent loan defaults, but they will reduce the lender’s risk of losses if borrowers in these programs do default.
  • Stimulate the economy. By encouraging lenders to extend credit, the government is effectively stimulating the economy – without having to use all of its own money. The increase in available loans will mean consumers will have more money to buy homes (or refinance to a lower rate), which will have trickle-down effects in other parts of the economy, such as home-building, moving, appliance sales and the home improvement industry.
  • Promote homeownership. The original reason the FHA, Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) were created was to promote more homeownership. In particular, the FHA loan introduced mortgage loans with longer terms (up to 30 years) and lower down payment than what had been available in the past.

It’s not just homeowners who receive government loan guarantees, however. Many companies and businesses also receive government-provided loan guarantees, especially through programs like SBA (Small Business Administration) loans.

Finally, loan guarantees are an increasingly popular type of foreign aid. By providing loan guarantees to developing nations or allies, the US can help countries acquire necessary financing from private sources. For example, if the US provides $10 billion in loan guarantees, the country receiving that guarantee can go to a commercial bank and borrow loans of up to $100 billion, or more.

The loan guarantee assures the lender that the guarantor (in this example’s case, the United States) would cover the first $10 billion of any loan default losses.

Why loan guarantees are required

Loan guarantees help overcome possible loan application denials. Lenders are more willing to issue a loan to a borrower if there is a loan guarantee involved as part of the loan agreement.

The most common reason that loan guarantees are required is because the borrower has insufficient credit to qualify for the requested loan program or amount. The borrower may have bad credit scores or a less-than-perfect credit report. In the case of many student loan borrowers, the student applicants simply may have no credit history at all.

When a lender issues a guaranteed loan, the third party or cosigner will still be evaluated by the lender to ensure sufficient income to service the new debt, as well as a solid credit profile.

Parties that agree to act as a guarantor must be aware that their credit history can be negatively affected should the primary borrower go into default or have late payments recorded in the payment history of the loan. For those who agree to cosign, even if one payment is more than 30 days past a due date, the delinquency can appear on the cosigner’s credit report at the same time.

Lenders who serve certain segments of consumer lending that include borrowers with recent credit problems or for those wishing to establish a credit history may rely on loan guarantees to issue a loan that may not have been placed without a guarantee. Guaranteed loans have a solid place in the consumer lending environment, extending credit to those who might not otherwise qualify on their own.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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