In 2008, the global financial markets experienced one of the most damaging crises in history. It took at least half a decade for major markets like the U.S. to recover following a series of quantitative easing schemes. While there were several forces behind the collapse of the financial markets, one of the most notable ones was defaulting mortgage borrowers. These defaults followed the housing boom in the mid-2000s.
It has taken the housing market nearly a decade to reach levels close to the highs of the pre-2008 to 2009 financial crisis, and now some are suggesting there could be a few housing bubbles around the world that are about to burst. In response to these speculative fears, banks are being exceedingly cautious when issuing loans, especially to consumers and small businesses. This has forced some consumers and businesses to go scavenging for loans in alternative markets where they risk falling into the traps of illegal lenders.
It is also very difficult to spot such lenders because even some companies that are legally registered as lenders have been accused of preying on unsuspecting borrowers by charging high interest rates on the account of being high-risk customers. One of the most popular cases was directed to Warren Buffett (Trades, Portfolio)’s Clayton Homes two years ago, when his company was accused of trapping buyers with high interest rates, leaving them with unaffordable loans on depreciating homes. Buffett unapologetically quashed those accusations, stating Clayton’s buyers posed high risks, hence the high interest rate charges.
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While interest rates and lending rates remain low, an economic meltdown could easily send markets tumbling, leading to negative rates. As such, lenders have established methods of protecting themselves, including widening the bracket of borrowers that may require a guarantor for their loans. This reduces the number of borrowers under the category of high-risk loans.
On the other hand, corporate governance authorities have moved to implement their own measures to ensure financial institutions are well prepared for the next financial crisis. Banks are required to meet Basel III rules, while interest rates on high-risk loans like guarantor loans and payday loans have been capped.
How do guarantor loans reduce risk exposure to lenders?
Generally, guarantor loans provide a safe haven for people whose credit scores are not particularly kosher. These loans are very much like unsecured personal loans, with the only difference being you, the borrower, are “guaranteed” by someone else known as a guarantor. Guarantors assume the risk of default, which means in case you default your payments, your credit provider can subject your guarantor to pay up the loan. This is how lenders cushion themselves against potential defaulters. In return, they increase the amount of loans issued, thereby boosting interest income.
Guarantor loans are not new to the market. They are among the most ancient financial products in the banking sector. Over the last decade, however, the number of guarantor loan lenders has increased. Today, it's quite easy to access various loan types including payday loans, guarantor loans, and auto loans online. Many online lending platforms have cropped up over the last few years and some of their strongest selling points are that they make loan applications and processing simpler and quicker.
Due to the increasing number of illegal lenders, however, various financial regulatory authorities have moved to protect consumers by capping interest rates charged on these types of loans. Most guarantor loans lenders are also payday loans lenders. Both products are mainly issued to borrowers whose credit scores leave a lot to be desired. Some of these loans used to attract interest rates as high as 400%, but things have changed over the last few years.
In 2015, a review was done in the U.K. by the Financial Conduct Authority (FCA) to determine whether capped interest rates on payday lending drove vulnerable consumers into borrowing from dangerous loan sharks. The findings were alarming, leading to the introduction of interest rate caps in response to concerns among lawmakers and the Church of England.
The cap, which guaranteed no one had to pay more than twice the amount borrowed, resulted in significant improvements for consumers and a spike in guarantor loans borrowing. In a blog for MoneySavingExpert.com, FCA Chief Executive Andrew Bailey outlined his views about the new changes. He said, "We have to be careful that we do not create a market which encourages illegal lending."
In the U.S., every state has its own regulatory measures on these types of loans, but there are proposals on the table for a federal law that caps interest rates charged on payday loans as well as increasing the time limit for repayments.
Guarantor loans offer a multitude of benefits to consumers. First, the loans are easily accessible because most credit providers do not charge any application fees – for some, everything is done online.
Second, loan payout is done on the same day of application, which gives customers quick access to the finances. Finally, the loans can be “an all-purpose,” which makes them suitable for anything between getting a new car, education fees, home improvements or even debt consolidation.
While things might be appealing in the eyes of the borrower when receiving the loan, repayments have often ended in crisis, with some lenders taking legal action against borrowers. Extensive high-risk borrowing can easily lead to a financial crisis in a similar fashion to that of 2008 and 2009 if measures are not taken to control activity in the market.
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About the author:
Nicholas has solid knowledge of both U.S. and European markets. His investment style is focused on undervalued plays and growth stocks. As a trader, Nicholas classifies himself as a swing trader and likes to trade GBP/USD, gold and FTSE 100, among other liquid instruments.