Monday, 4 January 2010

Why charge for a personal guarantee?

From time to time, people wonder if they should assume a personal guarantee for a company they are associated with or a person they know. This is a personal decision, but I believe that to correctly and rationally make this decision, one needs to be able to quantify the cost of the decision.

The risk of a default, even from family member has a cost. This is not a zero value. It also may be a debt that follows you even after you have stopped being a director with a company. Risk has a cost. This is what the nature of interest is based on. We all like to believe that a company we are associated with will not fail, but this is not always the case. On top of this, if the company is sold, it could be sold without a transference of the guarantee. This means that you are left with the debt whilst receiving no consideration.

Next, this is a direct cost. Legally, you have to declare the guarantee on all loan applications. This both lowers your credit rating and also increases the expected interest that you will be charged if you obtain a loan. When calculating the maximum amount that you can apply for (for instance a home loan) the guarantee will be included in this amount and will hence lower your capacity to borrow money.

If you do not disclose the guarantee and fail to repay a loan, you could be charged with fraud. This will also allow the financial institution to recover on real property even on an unsecured loan.

Finally, risk is a cost. Risk is the probability of a loss being solidified. As a result, you can directly quantify the cost associated with a risk by calculating the likelihood of loss by the loss if solidified. There are more advanced (and hence accurate means to do this - such as MCMM or Monte Carlo Markov Methods) as well but the cost of the calculation also should be considered.

The end result is that if you have an expected 5% (once each 20 occurrences) likelihood of a loss (this is a low expectation) of a $250,000 guarantee, you can hence associate a direct cost of $12,500 to the guarantee.

You may decide to wear this cost or to transfer it, but it is important that you know it exists so that you can account for it correctly.

No comments: