As the market takes off, more buyers are turning to the bank of mum and dad. What are the risks?
With the market running at full tilt, and first home buyers still leading the charge, more and more people have been asking me about guarantor loans.
I think most people have got the general gist, but let me step out the basics, and explain when I think they’re a good idea, and when they’re not.
Who Can Go Guarantor?
Now we typically think of guarantor loans being another act of tireless sacrifice of parents for their children. And this is typically what the bulk of guarantor loans are going to be.
However, it doesn’t need to be your folks. In the eyes of a bank, a guarantor has to be someone with a ‘strong relationship’ with the buyer, and the guarantor must be receiving some kind of financial benefit.
So we’re typically talking family. Not just parents, but also grandparents or siblings or de facto partners.
And the financial benefit is that they don’t have to sell their house or dispose of other assets to be able to help out the buyer.
So you know, you can’t just ask your mate to go guarantor on your loan. It’s not going to fly.
Guarantor loans can also be relevant for trusts, but let’s not open up that can of worms just yet.
How do Guarantor Loans work?
So there are actually two types of guarantee a guarantor can offer. The first is around serviceability. The second is around the deposit – the security.
Most often we’re talking about a security guarantee, where the guarantor is offering up assets or equity in their own home.
Remember, banks want you to have some skin in the game. That’s what the deposit is for. The deposit provides a buffer between what the bank will receive if you
default and they have to sell your house, and how much money they actually lent to you.
The deposit means that it’s almost impossible for the bank to lose money.
The guarantor’s equity is doing the same thing. It’s the skin that you and your family are putting in the game. It’s what protects the lender if worse comes to worst and you have to default.
And that’s why the guarantee is useful. It potentially allows you to need less of a cash deposit ready to go, and potentially get your LVR down so you can avoid Lenders’ Mortgage Insurance.
What are the risks?
While it should be unlikely if you’re not stretching yourself too much, if your parents are using equity in the house, then their house is, theoretically, at risk.
So if you default, the lender has the ability to hit your parents up for any shortfall, potentially forcing them to sell the asset they put up as security.
However, the bank is really just interested in the money, and if the capital can come from other sources, they’re not going to force your parents to sell just for the sake of it.
The thing to note is they are not exposed to the full price of the house – just the shortfall between the value and the loan.
So if you’ve got a 10% deposit, your parents offer another 10% through equity in their home to get you up to a 20% deposit (and therefore avoid LMI), then your parents are only on the hook for 10% of the purchase price, at most!
The other thing to remember is that if your parents are guarantor on a loan, this liability will be factored into their serviceability calculations if they want to go for a loan themselves in the future.
Right for you?
I think guarantor loans can be useful for getting your kids set up with their first home. The first home really is the first step on the road to wealth, and I think it generally is a case of the sooner the better.
That said, I generally encourage people to think about their first home through the lens of a deal-maker mindset. I’ve talked about this before, but there are just so many options when it comes to property, and just buying a vanilla property with a vanilla mortgage is just one of them.
I’d encourage both kids and parents to explore some of the options, and see if there are creative ways to engineer a deal that gets the kids in a home and protects the parent’s equity.
I’ve seen it happen, time and time again.
A guarantor loan might still be the best way forward, but you’ve got to explore the options for a deal first.