What is a guarantee?

A guarantee involves three parties: the creditor (the lender or supplier who is owed money), the principal debtor (the person or business that owes it) and the guarantor (who steps in if the debtor does not pay). The guarantor's obligation is secondary. It supports the debt rather than replacing it, so the creditor calls on the guarantor only once the debtor has failed to pay or perform.

Creditors usually insist on a written, signed guarantee, executed either as a deed or as a simple contract. The document sets out the extent of the guarantor's liability (unlimited, capped or limited), whether the guarantee is continuing or covers a single loan, and what has to happen before the creditor can make a demand.

Guarantees come in several forms. A limited (capped) guarantee sets a dollar cap on what the guarantor can be asked to pay, while an unlimited guarantee exposes them to the full debt. A continuing guarantee covers an ongoing facility and future borrowing under it; a one-off guarantee covers a single transaction. A conditional guarantee only applies once certain events have occurred, whereas an unconditional guarantee lets the creditor demand payment as soon as the debtor defaults.

Guarantees also differ in what they cover. A payment guarantee covers money owed; a performance guarantee promises that contractual obligations will be met, and is sometimes backed by a bank guarantee. Bank guarantees and letters of credit are separate instruments in which a bank gives its own independent undertaking to pay. Directors of a company are commonly asked to give personal guarantees for its debts.

If the debtor defaults, the creditor issues a demand to the guarantor. Many guarantees require the creditor to give notice and evidence of the default and the amount owing first. If the guarantor does not pay, the creditor can start recovery proceedings, obtain judgment and enforce it against the guarantor's assets.

Where the National Credit Code applies, the credit provider must give the guarantor a copy of the proposed credit contract before the guarantee is signed, and banks that subscribe to the Banking Code of Practice give similar warnings and encourage independent legal advice. Outside those, a commercial guarantor asks for the documents and takes advice as a matter of negotiation, not entitlement. Consumer protection and unfair contract terms laws can apply. A guarantee is generally discharged when the debt is paid, when the creditor signs a deed of release, or when the debt is transferred to a new debtor by novation. Before signing, guarantors often negotiate a dollar cap, an expiry date or a release on refinancing.

The main risk is financial exposure, which can be substantial and, under an unlimited guarantee, open-ended. A continuing guarantee may also cover future borrowing the guarantor never anticipated. Being a guarantor can reduce your own borrowing capacity, because lenders count it in your commitments when you apply for a personal loan or business finance.

If the guarantee is secured, personal and business assets, including a home, can be at risk. Directors who guarantee company debts face a higher risk of personal insolvency if the company fails. Disputing enforcement can be costly, so independent legal advice before signing is the standard precaution, particularly for unlimited guarantees or where the creditor can increase the liability at its discretion.