To understand what a guarantee is, think about the fact that every business will at some point need to take out a loan. In most cases, banks and financial institutions want a guarantor for the loan they are about to provide. That's what the guarantee is about.
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What is a Guarantee?
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A guarantee is a legal promise made by a third party (the guarantor) to ensure that a borrower's debt or other type of liability under a contract is repaid or fulfilled. Loans guaranteed by a third party are known as secured loans.
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The guarantee can be limited or unlimited. An unlimited guarantee implies that the guarantor will meet the full liability, while with a limited guarantee the guarantor will meet only a portion of the liability.
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“For people who have never had a loan or have a poor credit history, guarantees help them get loans that would normally be inaccessible.”
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Types of guarantees
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What is the Personel Guarantee?
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The term personal guarantee refers to an individual's legal promise to repay the loans of the business of which he or she acts as the chief executive officer. Providing a personal guarantee means that if the business is unable to pay its debts, the individual will be liable for those debts.
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Personal guarantees are used in credit transactions to secure funding for new and small businesses. In personal guarantee, the owner of the company pledges his own assets and agrees to repay the debt from personal capital in the event the company defaults.
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The advantage of a personal guarantee is that it gives you access to more lenders and lower interest rates. The main disadvantage of a personal guarantee is that it is very simple. If your business is unable to pay its debt, you are personally responsible for it. This means that lenders can collect on you as an individual, and that puts your personal assets at risk.
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What is a Bank Guarantee?
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A bank guarantee is a promise from a bank to repay the debts of its customers in the event that such customers are unable to fulfill their contractual repayment obligations with another party.
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It is usually provided by commercial banks to companies involved in transactions with unfamiliar parties or foreigners to insure third parties from financial loss. This guarantee helps a company buy things that they normally cannot, thereby helping the business grow and boost its business.
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There are two main forms of bank guarantee used in businesses, which are:
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Financial Guarantee – Finance Guarantee. These guarantees are usually issued in lieu of security deposits. Some contracts may require a financial commitment from the buyer such as a deposit. In such cases, instead of a deposit, the buyer can provide the seller with a bank guarantee to ensure that the seller is compensated for any loss.
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Performance Guarantee – Performance Guarantee. These warranties are issued to fulfill a contract or an obligation. In case of breach of contract, the damaged person will be settled by the bank.
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To better understand what a Performance Guarantee is, see the following example. A contracts with B to complete a project and the contract is backed by a bank guarantee. If A fails to complete the project on time and does not compensate B for damage, B can claim the bank for damages by means of a bank guarantee.
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How Bank Guarantee works:
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Buyer and seller agree on the terms of the contract. Buyer agrees to pay.
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The buyer will then apply for a guarantee from his bank.
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The buyer's bank issues the required guarantee based on the information in the contract between the buyer and the seller. The guarantee is then sent to the seller directly from the buyer's bank in the form of a hard copy by post or a soft copy by email.
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After that, the transaction between the buyer and the seller is ready to begin.
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Advantages of bank guarantee
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Bank guarantees reduce the financial risks associated with business transactions. Due to its low risk, it encourages the seller/beneficiary to expand their business on a credit basis.
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Banks often charge low guarantee fees, which benefits even small businesses.
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When banks analyze and confirm the financial stability of the business, the reputation of the business will increase and this will increase business opportunities.
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Most guarantees require fewer documents and are processed quickly by banks (if all documents are filed).
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Disadvantages of bank guarantee
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Sometimes, banks are too rigid in assessing the financial position of the business. This makes the process complicated and time consuming. With the strict assessment of banks, it is very difficult for loss-making businesses to get a bank guarantee.
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For some guarantees involving high-value or high-risk transactions, the bank will require collateral to process the guarantee.
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Bank guarantee fee
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In general, the bank guarantee fee is based on the risk the bank takes on each transaction. For example, financial guarantees are often more risky than performance guarantees. Therefore, the financial guarantee fee will be higher than the contract performance guarantee fee. Depending on the type of guarantee, the fee is usually 0.75% of the guarantee value/quarter or 0.50% of the guarantee's validity period.
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In addition, the bank may also charge an application fee, a document fee, and a processing fee. In some cases, the bank requires a guarantee from the applicant, usually 100% of the guarantee value. In some cases, collateral or cash collateral may also be accepted by the issuing bank.
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In short, what is a guarantee? It is a legal promise by a third party (guarantor) to cover a borrower's debt or other types of liability in the event the borrower defaults. Hopefully, through the content shared above, you have a better understanding of this familiar term.
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Tram Nguyen
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