How Does a Guaranteed Loan Work?

A guaranteed loan is a loan backed by a third party that will pay back the loan if you default.

Definition and Examples of Guaranteed Loan

A guaranteed loan means that a third party has promised to repay the loan if the borrower defaults. Guaranteed loans make it possible for high-risk borrowers to access the funds they need.

When a loan is guaranteed, lenders are more willing to work with borrowers who are not generally considered good candidates for loans.

• Alternate definition: A debt that a third party pays if you can’t.
• Alternative name: Guaranteed mortgage

For example, the federal government provides guaranteed mortgages to borrowers who might not otherwise be able to obtain home loans. Borrowers apply for a mortgage through a private lender, and the government backs the loan. These mortgages are typically backed by the Department of Veterans Affairs (VA), the Federal Housing Administration (FHA), and the US Department of Agriculture (USDA).

How does a guaranteed loan work?

Borrowers who want to buy a home may not always meet the credit or down-payment criteria to qualify for a conventional mortgage. For example, their credit score may not be high enough or they may not be able to afford the 20% down payment.

The federal government provides guaranteed mortgages to these types of borrowers. Borrowers will apply for a mortgage through a private lender, and have the VA or FHA guarantee the loan. This allows borrowers to access the funds they need, and it protects the lender from the risk of default.

Guaranteed Loan vs Secured Loan

It is easy to confuse guaranteed loans with secured loans, but they are not the same. Both types of loans are low-risk for the lender, but the loans operate in different ways.

A guaranteed loan is backed by a third party, and if the borrower defaults, the third-party repays the loan. With a secured loan, the borrower may be required to pay a usage fee.

A secured loan is backed by an asset that is used as collateral, and the lender will seize the asset if you default. For example, if you take out an auto loan, the vehicle is used as collateral. If you default on the loan, your lender will seize your vehicle.

Types of Guaranteed Loans

Mortgages are not the only type of guaranteed loan program available. Let’s look at three other examples of guaranteed loans:

Student loan

The federal student loan program is another example of a guaranteed loan. Borrowers start by filling out the Free Application for Federal Student Aid (FAFSA), and the Department of Education endorses the loan. Federal student loans have no credit requirements and come with low-interest rates.

Payday loans

Payday loans are usually small loans of $500 or less, and the balance is due on your next payday. You’ll use your next paycheck to guarantee the loan, and your lender will electronically debit your account on the agreed date. But payday loans can come with APRs that reach 400%, which is why they’re banned in some states.1

Federal home loan program

The VA, FHA, and USDA offer a variety of guaranteed mortgages designed to make homeownership affordable. For example, the USDA guarantee for a single-family-home mortgage covers 90% of the money loaned by the lender to the borrower.2

SBA loan

The SBA offers guaranteed loans to help small businesses access the money they need. A business applies for a loan through a bank or lender, and the SBA guarantees a certain percentage of the loan.

key takeaways

• A guaranteed loan is backed by a third party, which can be an individual, company, or organization.
• Guaranteed loans give high-risk borrowers a way to access financing, and provide protection for the lender.
• A guaranteed loan is not the same as a secured loan.
• Secured loans are backed by an asset, whereas a guaranteed loan is backed by a third party.
• Mortgages, federal student loans, SBA loans, and payday loans are all examples of guaranteed loans.