Borrowing money

When you get a loan, the bank will usually require a mortgage and guarantee.

The loan relates to the amount of money you are borrowing from the bank and contains the bank’s lending terms that you have agreed to, such as the interest rate, repayment plan and the security required by the bank.

A mortgage is a charge that will be registered against the land belonging to the borrower or a related party.  This is the bank’s way of securing the money it has loaned and ensuring that the loan will be repaid.  If the loan is not repaid, the bank has certain rights as a mortgagee to enforce the loan and take over or sell the mortgaged land.

A guarantee is a promise by someone else to repay the loan if the borrower fails to repay it.  Depending on who the borrower is, the bank will require guarantees from the directors or shareholders of a company, the trustees of a trust, husband or wife of the borrower, or another related party that has enough equity to repay the loan if the borrower cannot.

For example, a common scenario is a closely held company taking out a business loan.  Husband and wife are the directors and shareholders; they own a family home in their own names and have some money in the bank.  The bank agrees to the business loan provided the directors guarantee the loan and use their family home as security for the loan.

Getting a bank loan is not simply a case of “sign here” and you’re on your way.  The bank needs to protect its own position by making sure there are back ups in place incase you fail to repay the loan.

Risk involved

Having a mortgage registered against your property puts your property at risk of being taken over or sold by the bank if the loan is not repaid.

The terms of a mortgage give the bank the right to enforce the mortgage in the event of default by the borrower.

The borrower defaults when they fail to make the required mortgage repayments.  If that happens the mortgagee can enforce the mortgage by taking over the property or forcing a sale of the property; this is commonly known as a mortgagee sale.  If this happens, out of the sale proceeds, the bank will take the full amount owed to them including the cost of enforcing the mortgage and you will receive whatever is remaining, if anything.  If the sale proceeds are not enough to cover the amount owed to the bank, then you may be made bankrupt.

You need to be confident that the rewards outweigh the risks.  Can the borrower meet the mortgage repayments? Is it worth putting your house at risk and risking bankruptcy?

When a personal guarantee is given by a shareholder or director of an incorporated company the limited liability protection is in effect eroded.

If a guarantee was not given, only the company would be liable for the debt.  The bank would not be able to go after the shareholders.  The directors would only be liable if they acted recklessly, fraudulently or negligently.  Limited liability protection is the main reason for incorporating a company.  This reason is defeated when a personal guarantee is given.

If you want to make the most of the limited liability of the shareholders and directors of the company, think twice about giving a personal guarantee for a business loan.

There is a huge amount of risk involved in giving a guarantee:

  • The guarantee is likely to cover all the current and future debts of the borrower, not just the amount of the current loan.
  • It continues until the bank releases you in writing.
  • It is a good idea to negotiate a maximum limit for a guarantee; otherwise you may end up guaranteeing an unlimited amount.
  • If you have a bank account with the same bank, the bank may use your money to satisfy the debt owed by the borrower.
  • You will be signing as guarantor and as principal debtor; that means the bank may choose to demand payment from you rather than trying to recover the debt from the borrower first.
  • It is up to you to monitor the financial position of the borrower and satisfy yourself that the borrower is able to repay the loan.
  • The giving of a guarantee could affect the ability of the guarantor to borrow money in the future for his or her own projects.  From the bank’s perspective, the amount potentially payable under the guarantee is a debt owed by the guarantor.

The giving of a guarantee is always a serious undertaking and one that should not be entered into lightly.

Get Advice

It is important to get legal advice from a lawyer that is independent from the bank and the other borrowers.

A lawyer will go through the documents with you and explain the effect and implications of the transaction as it applies to you.  If you see a lawyer that is not independent from the bank or other borrowers, that lawyer will not be able to advise you properly if your position conflicts with the position of the bank or other borrowers.  Lawyers have a duty act in the best interest of their client.  As borrower or guarantor, your interests are different from those of the bank and other borrowers.  That means the lawyer cannot discharge their legal obligations and advise you properly – so they must send you away.

In certain circumstances the bank is put on notice and taken to have presumed that the guarantor has been unduly influenced by the borrower to give a guarantee.  In those circumstances the bank cannot enforce the guarantee unless, before taking the guarantee, it has taken certain steps to make sure the guarantee is not given as a result of undue influence.  Those steps include sending the parties to a lawyer to receive independent legal advice.  To protect themselves, the bank requires the lawyer certify that they have advised the parties of the need for independent advice and explained the effects and implications of the transaction.  By doing this, the bank passes the responsibility of explaining the transaction and potential liability on to the lawyer.  And, once the transaction is entered into the guarantor cannot dispute the fact that he or she is legally bound by the documents.

It is important to have the transaction and the associated risks explained to you by a lawyer who is committed to acting in your best interest.

Be Aware

Be aware that guarantees can be hidden in all sorts of agreements and terms of trade.

Guarantees are not just required by banks.  They are also required by most businesses that supply goods or services on credit.

Businesses that let you “buy now and pay later” will usually require you to agree to their terms and conditions of trade.  These are usually found in small print on the back of an invoice or credit application form.  Most people sign the form and agree to the terms without reading them or considering the risks involved.  Unlike banks, these traders are not required to send you to a lawyer to have the risks and implications explained to you.

These hidden guarantees pack just as much punch as a bank guarantee.  They are usually personal guarantees, meaning that the person signing agrees to the terms on behalf of the company and in their personal capacity.  That means if the company cannot afford to pay the invoices, the person who signed the document personally guarantees the invoices will be paid.  They are putting all their personal assets at risk.  If they do not have enough assets to cover the amount owed then they may be made bankrupt.

An example of when this may occur is with large chain stores and building supply companies that allow goods and services to be taken on credit.  These big businesses protect their position by having properly prepared terms and conditions of trade that contain a personal guarantee clause.  They know their rights and do not hesitate to commence debt collection proceedings against customers and guarantors that do not pay.  In the current economic climate these big companies tend to make a few people bankrupt each month.

It is important to always read the small print before signing anything and where money is involved, keep an eye out for hidden personal guarantees.  You may be able to negotiate and cross out the guarantee clause.

Limit Your Exposure

Borrowing from a bank can be a necessary evil that is required to achieve your goals.  However, there are ways to limit your exposure under loans and guarantees.

Banks require security for loans when there is a risk that the borrower cannot repay the loan.  If the borrower’s financial position improves or a substantial amount of the loan has been repaid, it is worth seeing the bank about reducing the security required by removing the mortgage or releasing the guarantors.

Instead of giving a guarantee, a better option is to loan money to the borrower so that they can borrower less from the bank.  If they borrow less, the bank is likely to require less security; that may mean no mortgage or no guarantee is needed.

Overall the best way to limit the risks is to be informed and know what you are getting yourself into.  All loan, mortgage and guarantee documents are different and you should not simply “trust” the person who is asking you to sign the document.  Be responsible, seek your own advice and make an informed decision about whether to sign the documents.

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