If we can speak very generally for a second, over the past few years, the gap between Australian property prices and wage growth has widened dramatically, with the strain being felt particularly in Sydney and Melbourne. This has made things pretty difficult for first home buyers saving for a deposit, whilst also trying not to exist solely on instant Mi Goreng.
As a result, many home buyers are turning to family for help, by way of a guarantor loan. So, we thought we’d put it under the microscope, and give you everything you need to know (for both sides of the coin).
A guarantor loan is…
To put it really simply, a ‘guarantor’ is someone that ‘guarantees’ a loan, or portion of a loan, for someone else. A guarantor loan can come under many different names depending on the lender (i.e. a family guarantee, family pledge, parental guarantee) but the concept remains relatively similar.
In almost all cases, the guarantor will either be a parent or immediate family member of the borrower, and they will often use their own home as extra security for the new loan. Effectively, they will be required to hypothetically cover the difference in principle until the borrower can afford to take the reins themselves, or until they are called upon to repay the portion of the debt which the borrower could not cover themselves.
Sounding like a big commitment? It absolutely is! But unlike a co-borrower, a guarantor can eventually be released, and their responsibility for the loan stopped without the loan having to be paid out.
How does a guarantor loan work?
A guarantor will generally be required to use their own home (or the equity in their home loan) as extra security for the borrowers new loan, which basically means that the loan is secured by both the property being bought and the property owned by the guarantor.
In terms of benefits, this can help the borrower in either:
- purchasing a property with a smaller (or sometimes non-existent) deposit
- avoiding an LMI (Lenders Mortgage Insurance) fee
- servicing guarantee
As far as the guarantee itself goes, this will more often than not only consist of a portion of the new loan, and once repayments have been made to this amount, or if the property value increases sufficiently to reduce the overall LVR below 80%, the guarantor can then be released from the loan.
Why use a guarantor loan?
For those struggling to satisfy the financial requirements of a property purchase in a strong market, a guarantor loan can help in a few ways:
Pros
- Buy with less (or no) deposit: For those finding it difficult to save enough to satisfy a 20% deposit (plus all the other associated costs involved in a property purchase) a guarantor loan can be a great way to get over the line.
- Avoid LMI: Any loan that is more than 80% of the property value will be subject to a Lenders Mortgage Insurance (or LMI) fee. The amount will vary depending on the lender, but it can end up being a hefty expense.
Cons
- Relationship stress: Having someone go guarantor on your home loan is a big ask, and if things don’t go according to plan, it can put increased strain on the relationships between those involved. It is critically important that both parties are across all obligations and risks associated with the transaction, and a plan is put in place to release the guarantor as soon as possible, to minimise risk and stress.
Why become a guarantor?
By becoming a guarantor, you may mean the difference between the guarantee securing a property, and not. Which is an amazing gift! But is also a big commitment, that should be fully explored through the guidance of a professional before any steps are taken.
Pros
- A helping hand: Truthfully, you’re really only ever becoming a guarantor to help someone else out, which is why these arrangements are pretty much exclusively acceptable between family members (the most common being between parents and their children).
- Limited guarantee: More often than not, a guarantor will only be required to guarantee a portion of a loan, which subsequently means they are only financially responsible for that portion. As a guarantor, this gives you more control over how much risk you are willing to be exposed to and will mean you will only be required as a guarantor for a limited amount of time.
Cons
- Risky business: Ultimately, if things go wrong the guarantor is liable for the debt, which includes covering the repayments if the borrower becomes unable to do so themselves. More on this later…
- Limited borrowing power: When someone agrees to become a guarantor, they are effectively adding the additional debt to their own, which can negatively impact their ability to borrow money themselves in the future (or at least until they have been removed as guarantor)
What if it goes wrong?
It isn’t as dire as you would think, and believe it or not, the banks will do their best to work with the borrower, in order to see the debt gets repaid. Calling on the guarantor, and subsequently, selling the guarantors property to pay any remaining debt, is an absolute worst-case scenario.
If the borrower was to find themselves unable to meet repayments on the proposed loan:
- First, they would be given the opportunity to work with the bank in order to adjust repayments so that the primary security (their property) won’t have to be sold – this is known as a ‘hardship application’.
- If that doesn’t help, or they fall behind on these repayments the property will then be sold. The money from this sale will be used towards the corresponding debt.
- If there is any debt remaining, they will be given the opportunity to repay it before the guarantor is called upon. Depending on their financial position and how much debt remains, they may be able to take out a personal loan to repay the remaining debt amount. Or they could find the funds through the sale of personal assets.
- If this isn’t a viable option, the guarantor is then given the opportunity to cover the remaining debt. This is usually achieved by taking out a new loan (or ‘second mortgage’) against their property.
- If this isn’t an option, it is probably then time for the guarantor to sell their property.
The bank will allow sufficient time for this to be resolved as long as the borrower maintains a dialogue with them. They will typically only pursue repossession as an option if parties are uncontactable or unwilling to work with them.
So, are they a bad idea?
Naturally, guarantor loans are that little bit trickier than your average home loan (although, what is average these days?) and it’s also important to note that not all guarantor loans are created equal. Different lenders will have different criteria and terms, so it’s really important that you speak to a mortgage broker about what will be best for you and your personal circumstances.
However, when implemented responsibly a guarantor loan can be incredibly effective, and we’ve seen many instances where this type of loan has helped many young, first home buyers get over the property purchase line. It’s all about managing the risk and reward, particularly from the guarantor’s point of view.
At Pure Finance, we like to place a particular emphasis on the ‘exit plan’ which is, having a strategy in place that aims to release the guarantor from the loan as soon as possible. This can be achieved when:
- the guarantee has made sufficient repayments to cover the guarantor loan portion
- The property value has increased sufficiently, to bring the LVR (Loan to Value Ratio) to 80% (to aid the guarantee in avoiding LMI)
Also, it’s recommended that both parties seek legal advice or have an agreement in place to ensure everyone is on the same page, and in some cases, the lender may stipulate this as a legal requirement for the approval of the loan.
Got some more questions about guarantor loans? Or perhaps, you just want to have a chat? We’re all ears! Reach us here: 1300 664 603 or here: info@nullpurefinance.com.au
The preceding information is of a general nature and does not take into account personal financial situations and endeavours. You should obtain advice based on your individual circumstances before acting on the above information.