Difference Between Bank Guarantee and Collateral
Whenever you apply for a loan, whether you are running a small or big organization, the bank or any other lending institution wants to be ensured about your capability to pay the loan. For this purpose, you are asked about your income sources and credit history so that the lender could be able to establish your credibility before granting the loan. However, if the amount of your loan is large or the lender does not find your credibility suitable for the said loan, you may be requested for the collateral or a guarantee. Now you must be thinking about how you get a loan against a bank guarantee or how it differs from collateral.
Let’s first start with understanding a BG:
What Is A Bank Guarantee?1. A bank guarantee, a type of trade finance is a guaranteed loan issued by a bank or any private financial institution to an individual or entity with a commitment of paying the debt amount in the event if the borrower defaults.
2. In other words, if the debtor is unable to pay the loan amount, the bank takes the responsibility to pay the debts and ensures that the liabilities of the borrower will be met.
3. This type of obtained loan is known as a guaranteed loan where a borrower (person or an entity) has appointed a third-party to pay the debt in the event of default.
4. Through obtaining a bank guarantee service, the debtor/customer/borrower is capable of getting the goods, or buying equipment, or drawing down a loan.
5. The lenders will only grant the loan to the borrower if they are satisfied either with the credibility of the borrower or has the borrower’s back-up in form of a third-party who is responsible to pay the debt and acts as the borrower’s guarantor.
6. If the borrower fails to cover the loan amount, the lender can take legal action against the guarantor for the debt.
How Does It Work?
The borrower can choose from the different types of bank guarantees for obtaining the loan amount. Here they are as follows:
1. Direct Guarantees -
Usually, banks consider direct guarantees in case of both domestic and foreign business as they are directly issued to the applying person. Talking about individuals, they also opt for direct guarantees in global or cross-border transactions due to its easier adaptations to overseas legal systems and fewer form requirements.
2. Indirect Guarantees -
These types of BG’s are widely used in export transactions especially when the beneficiaries of the guarantee include government agencies or public entities. Since some countries do not rely on foreign banks and guarantors due to the involvement of legal issues or other documentation requirements, indirect guarantees bring a second bank into the picture. It is usually a foreign bank that has a head-office in the beneficiary’s country of law.
3. Personal Guarantee -
A personal guarantee is a promise to pay the debt amount to the lender which is secured by personal assets. While applying for a loan, the borrower needs to sign a document clarifying the fact that he will pay the loan personally otherwise the lender can take legal action or can claim some or all of the borrower’s physical or financial assets.
What Is Collateral?
In case of using collateral to get a loan, the borrower is required to pledge one or more of his assets as security to the lender so that if he fails to pay the loan, the lender will have a backup to claim collateral that you have pledged and sell it to recover the loan amount.
It is a physical asset where the lender has a right to claim and sell to recover the debt.
In short, the concept of collateral deals with pledging any physical asset as a security for repaying the debt.
Now you know that collateral or BG both are the bank financial instruments that ensure the fulfillment of the financial commitments made by the borrowers.