No transaction, no risk? The influence of financial literacy on going guarantor

By Elisabeth Beckmann, Christa Hainz, Sarah Reiter
Posted on March 22, 2021

John gets the chance to purchase a popular local food franchise. Thinking it is a profitable investment, he applies for a business loan. His mother Mary agrees to go guarantor on the loan. However, business is slower than expected, and John fails to make his loan repayments. The bank turns to Mary, asking her to pay her son’s arrears, but alas, she can’t. The bank announces that Mary will be foreclosed. She ends up having to sell her house.[1]

John and his mother are just one example illustrating that granting a third-party guarantee (henceforth: guarantee) for someone else’s loan can have dramatic financial consequences. When that happens, those affected often seek the help of consumer-protection agencies. But by then, the horse has bolted, and there is usually no easy way out for the guarantor.

Let’s go back in time and consider Mary’s situation: how well did she understand the responsibility she was assuming when agreeing to act as a guarantor for her son? Would she have decided against granting a guarantee had she been better informed about the potential consequences of her actions? We aim to provide answers to these questions, investigating who is less likely to understand the consequences of granting a guarantee for other people’s loans, and whether better understanding affects a person’s decision to act as a guarantor.

Going guarantor: our TFI project

There is ample evidence showing that people with higher financial literacy make better financial decisions (Lusardi and Mitchell, 2014; Kaiser et al., 2020). In our TFI research project, we turn our attention to an aspect that has been neglected so far in the literature: the decision to act as guarantor for a loan. This decision involves three parties: (1) the bank as lender, (2) the borrower, and (3) the guarantor, who agrees to repay any outstanding loan amount including interest in case the borrower is unable to repay. For the guarantor it may be difficult to grasp the consequences, especially because acting as a guarantor does not involve an immediate financial transaction; ultimately, guarantors only have to provide a signature. However, this decision can rarely be reversed.

For our research, we use data from the OeNB Euro Survey, a survey of private individuals on household finance, conducted annually by the Austrian Central Bank in ten Eastern European countries. It covers six EU Member States that are not part of the euro area (Bulgaria, Croatia, Czech Republic, Hungary, Poland, and Romania) and four EU candidates and potential candidates (Albania, Bosnia and Herzegovina, North Macedonia, and Serbia). In each country and in each survey wave, around 1,000 individuals are interviewed. In the 2018 and 2019 survey waves of the OeNB Euro Survey, we introduced questions measuring knowledge about the financial and legal consequences of guarantees and on “acting as a guarantor.” In these countries, guarantees are relatively frequent: 5% of the population are currently acting as guarantors.

To gain a deeper understanding of the role of information in the process of granting guarantees, we plan to conduct another study, an information-provision experiment. This will be complemented with further analyses of the motivation and reasons for acting as a guarantor. Putting these findings together will allow us to obtain a comprehensive picture of how the decision to act as a guarantor is taken.

Preliminary research results

By analyzing the OeNB Euro Survey data, we have found that being knowledgeable about the consequences of granting a guarantee considerably reduces people’s propensity to become a guarantor. Our results suggest that many individuals could benefit from financial-education programs. Across the ten countries, on average, about 55% of individuals are aware of the consequences of guarantees.

The following figure shows that knowledge varies considerably across countries. In Croatia, 70.4% of the individuals are aware of the consequences. In Hungary and the Czech Republic, this share is still above 60%. More than half of the individuals in Romania, Bulgaria and Poland are knowledgeable. However, figures are below 50% in North Macedonia, Serbia, as well as in Bosnia and Herzegovina. In Albania, only 40.4% are aware of the liability they are taking on.

Source: Beckmann, Hainz and Reiter (2021)

As we might expect, the level of literacy differs between different groups. From our analysis we learn that literacy about guarantees is lower among younger individuals (18–35), individuals with lower education, individuals with lower income, and nonworking individuals. Somewhat surprisingly, we do not find a gender difference, which might be due to the communist legacy in the countries we are studying.

Preliminary recommendations

Let’s go back to Mary and John’s sad story to find out at what points of their negotiation process knowledge played a crucial role:

Firstly, Mary certainly signed a document at the bank in which she took over the obligation to repay the loan in case John is unable to do so. Did the bank provide Mary with information about the obligation in a simple and comprehensible way? And if so, did Mary fully understand the underlying responsibilities when signing the document? This brings us to our first recommendation: [2]

1. Potential guarantors should get an easy-to-grasp explanation of the consequences of their guarantee.

Secondly, it would have been important for John and Mary to familiarize themselves with the contents of the contract they planned to sign. This holds even more so as the contract does not involve an initial financial transaction. John and Mary should have made sure that they knew what it means to go guarantor. This brings us to our second recommendation:

2. Governments should promote financial education, preferably through financial agencies who provide legal and financial advice – ideally for free – and through financial-education programs covering the topic of guarantees.

Next steps

Our research results suggest that being aware of the obligation taken when becoming a guarantor improves financial decision-making. Increasing this awareness helps to avoid dramatic financial consequences as well as (sometimes serious) difficulties in interpersonal relationships.

The presented results are part of a larger research agenda studying the role of financial knowledge and social norms on the granting of guarantees. We are currently analysing how the decisions to grant or take a guarantee influence each other. We look forward to presenting our first results early 2022. Stay tuned!

Footnotes

  1. [1] This story is motivated by a case presented by Moneysmart (Going guarantor on a loan - Moneysmart.gov.au)
  2. [2] In the UK such a requirement has been introduced (Financial Conduct Authority, 2020).

References

  • Beckmann, Elisabeth, Hainz, Christa and Reiter, Sarah (2021): The Effect of Financial Literacy on Granting of Third-Party Guarantee, mimeo.
  • Financial Conduct Authority (2020): Consumer Credit Sourcebook (CONC). Retrieved from https://www.handbook.fca.org.uk/handbook/CONC/4/?view=chapter&timeline=true# (2020, February 16).
  • Kaiser, Tim, Lusardi, Annamaria, Menkhoff, Lukas and Urban, Carly J (2020): Financial Education Affects Financial Knowledge and Downstream Behaviors, NBER Working Paper 27057.
  • Lusardi, Annamaria and Mitchell, Olivia S. (2014): The Economic Importance of Financial Literacy: Theory and Evidence. Journal of Economic Literature 52:5–44.