# Understanding Financial Guarantees: Types, Examples, and Benefits

## What Is a Financial Guarantee?

A financial guarantee is a promise made to repay a loan or debt if the borrower cannot. This gives lenders protection and confidence in financial transactions. This guarantee comes from a third-party guarantor, which can improve a borrower’s credit rating and lower interest rates. Financial guarantees can take different forms, such as corporate or personal guarantees, making them an important tool for securing credit.

### Key Takeaways

*   A financial guarantee is a promise from a third party to cover a loan if the borrower defaults.  
    
*   Guarantees often improve borrower interest rates and lender credit ratings by acting like insurance.  
    
*   Guarantors may ensure full or partial debt repayment, but not all liabilities are covered.  
    
*   Financial guarantees facilitate lending to high-risk borrowers by mitigating default risk.  
    
*   Common forms of financial guarantees include corporate indemnities, letters of intent, and personal guarantor agreements.

## How Financial Guarantees Work

Some financial agreements may require the use of a financial guarantee before they can be executed. In many cases, a guarantee is a legal contract that promises [repayment](https://www.investopedia.com/terms/r/repayment.asp) of a debt to a lender. This agreement occurs when a guarantor promises to handle the debt if the original borrower defaults or becomes [insolvent](https://www.investopedia.com/terms/i/insolvency.asp). All three parties must sign the agreement in order for it to go into effect.

Guarantees may take on the form of a [security deposit](https://www.investopedia.com/terms/s/security-deposit.asp). Common in the banking and lending industries, this is a form of collateral provided by the debtor that can be liquidated if the debtor defaults. For instance, a [secured credit card](https://www.investopedia.com/terms/s/securedcard.asp) requires the borrower—usually someone with no credit history—to put down a cash deposit for the amount of the credit line.

Financial guarantees act just like [insurance](https://www.investopedia.com/terms/i/insurance.asp) and are very important in the financial industry. They allow certain financial [transactions](https://www.investopedia.com/terms/t/transaction.asp), especially those that wouldn't normally take place, to go through, permitting, for instance, high-risk borrowers to take out loans and other forms of credit. In short, they mitigate the risk associated with lending to high-risk borrowers and extending credit during times of financial uncertainty.

Guarantees are important because they make lending more affordable. Lenders can offer their borrowers better [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) and can get a better [credit rating](https://www.investopedia.com/terms/c/creditrating.asp) in the market. They also put investors at ease, making them feel more comfortable because they know their investments and returns are safe.

## Important Factors to Consider with Financial Guarantees

A financial guarantee might not cover all [liability](https://www.investopedia.com/terms/l/liability.asp); it could secure only the interest or principal.  

Sometimes, multiple companies sign on as a party to a financial guarantee. In these cases, each guarantor is usually responsible for only a [pro-rata](https://www.investopedia.com/terms/p/pro-rata.asp) portion of the issue. In other cases, however, guarantors may be responsible for the other guarantors' portions if they default on their responsibilities.

Financial guarantees often reduce default risks, but they aren't foolproof. We saw this during the fallout after the [financial crisis of 2007-2008](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp).

Many bonds are supported by financial guarantee firms, or [monoline](https://www.investopedia.com/terms/m/monoline.asp) insurers, against default. The global financial crisis severely impacted these firms. It left numerous financial guarantors with billions of dollars of obligations to repay on [mortgage-backed securities](https://www.investopedia.com/terms/m/mbs.asp) (MBSs) that defaulted, causing financial guarantee firms to have their credit ratings slashed.

## Exploring Different Types of Financial Guarantees

As noted above, guarantees may come in the form of a contract or may require the debtor to put up some form of collateral in order to access credit. This acts as an insurance policy, which guarantees payment for both corporations and personal lending. Here are some of the most common types of both.

### Understanding Corporate Financial Guarantees

In the corporate world, a financial guarantee is a non-cancellable indemnity, often a bond backed by an insurer or secure financial institution. It gives investors a guarantee that principal and interest payments will be made. 

Many insurance companies specialize in financial guarantees for debt issuers to attract investors. As noted above, the guarantee gives investors comfort that the investment will be repaid if the [securities](https://www.investopedia.com/terms/s/security.asp) issuer can't fulfill the contractual obligation to make timely payments. It also can result in a better credit rating, due to the outside insurance, which lowers the cost of [financing](https://www.investopedia.com/terms/f/financing.asp) for issuers.

A [letter of intent](https://www.investopedia.com/terms/l/letterofintent.asp) (LOI) is also a financial guarantee. This is a commitment that states that one party will do business with another. It clearly lays out the financial obligations of each party but may not necessarily be a binding agreement.

LOIs are commonly used in the shipping industry, where the recipient's [bank](https://www.investopedia.com/terms/b/bank.asp) provides a guarantee that it will pay the shipping company once the goods are received.

### Knowing Your Options: Personal Financial Guarantees

Lenders may require financial guarantees from certain borrowers before they can access credit. For example, lenders may require college students to get a guarantee from their parents or another party before they issue student loans. Other banks require a cash security deposit or form of collateral before they give out any credit.

> **Important**
>
> Don't confuse a guarantor with a cosigner. A cosigner's responsibility for a debt occurs at the same time as the original borrower, while the guarantor's obligation only kicks in when the borrower defaults.

## Real-World Example of a Financial Guarantee in Action

Here's a hypothetical example to show how financial guarantees work. Let's assume that XYZ Company has a [subsidiary](https://www.investopedia.com/terms/s/subsidiary.asp) named ABC Company. ABC Company wants to build a new [manufacturing](https://www.investopedia.com/terms/m/manufacturing.asp) facility and needs to borrow $20 million to proceed.

If banks determine that company ABC has potential credit deficiencies, they may ask XYZ Company to become a guarantor for the loan. That means that if ABC defaults, XYZ Company must repay the loan using funds from other lines of business.

## The Bottom Line

A financial guarantee is a promise by a guarantor to repay a debt if the original borrower defaults. It helps reduce risk, making it possible for high-risk borrowers to get loans. These guarantees come in various forms, such as security deposits, collateral, or contracts. However, they may not always cover full liability and can be strained during economic downturns, as seen in the 2008 financial crisis. Despite these risks, financial guarantees remain important in corporate and personal finance, as they can improve credit ratings and allow borrowers to access better interest rates.  

> **Article Sources**
>
> 1.  Upcounsel. "[Financial Guarantee: Everything You Need to Know](https://www.upcounsel.com/financial-guarantee)." Accessed July 1, 2021.
>     
> 2.  Surety Bonding. "[FINANCIAL GUARANTEES](https://www.bondsurety.ca/Financial-Guarantees.htm)." Accessed July 1, 2021.
>     
> 3.  LawDepot. "[Letter of Intent FAQ - Canada](https://www.lawdepot.com/law-library/faq/letter-of-intent-faq-canada/#.YHxTqS1h2_w)." Accessed July 1, 2021.