Rapidly rising house prices have seen the median price of homes across major cities hit record highs. In Sydney alone, the median price has increased 8.5% in the first quarter of the year, soaring to $1.3 million (the fastest quarterly gain in almost 30 years). This growth is reflected across the board with median prices reaching $974,000 and $927,000 in Melbourne and Canberra respectively. *
The remorseless momentum of rising prices means that the average deposit required for a home is now approximately $107,000, which in turn takes an average of 6-8 years to accumulate. The “great Australian dream” of home ownership seems to many young first home buyers to be an overwhelming, if not impossible, objective.
So it is not surprising that an increasing number of young people look to their parents to help them break into the property market. In fact, it has become so commonplace that the Bank of Mum and Dad is now the nation’s ninth-largest mortgage lender with almost $34 billion in loans.***
Overall this is a good thing – what are families for if not for mutual support. However, parental generosity has its own price, which can be very high if not done astutely. If parents are fortunate enough to be in a financial position to lend a helping hand to their children, it is imperative they take into consideration the risks involved in order to be able to protect their own assets and wealth.
One of the most common methods parents use to help their children purchase their first property is a guarantor loan.
WHAT IS A GUARANTOR LOAN?
A guarantor loan enables first-home buyers to avoid lenders mortgage insurance (LMI) when buying with less than a 20 per cent deposit. These loans are structured in such a way that the loan to the children is secured by both the property being purchased and the property owned by the guarantor parents.
The parental guarantor has a dual role in this loan. Firstly the parents use their own property (or the equity in it) as security to guarantee either the entire loan or a portion of it. Secondly, they assume responsibility for the loan in case the borrower can’t make repayments.
The decision to become a guarantor imposes significant obligations that can impact the parents’ current and future financial position. Most seriously if things go awry, the parents’ long term financial objectives and even retirement plans may be seriously derailed! Therefore it is essential to carefully and thoroughly think about your own situation and what financial consequences you may face if your child defaults on their loan due such things as to sickness, unemployment, or relationship breakdown.
WHAT ARE THE RISKS WHEN GOING GUARANTOR?
There are a number of risks that should be considered prior to going guarantor. The repercussions can be severe – worst case you may have to sell your own home to service or clear the debt if things go wrong.
Risk #1: It could lower your borrowing capacity
If you have become guarantor for your children, and then want to borrow yourself, you will need to inform your lender of the guarantee. Whether or not you are making any repayments is irrelevant – the loan that you have guaranteed will be taken into account by the credit provider while assessing your borrowing capacity. This may limit your ability to invest for yourself, your retirement or other children.
Risk #2: Your credit rating is at risk
If the borrower defaults on the guaranteed loan and you are called upon to make the repayments but fail to do so, the default will stay on your credit file, making it more difficult for you to borrow in the future.
Risk #3: Loan default
If your child defaults on the loan, you may be called on to repay the entire loan amount plus interest. In this instance, the lender will often sell your child’s home first in order to discharge the mortgage. However in the event of a shortfall, you may have to pay back the entire outstanding debt. If you cannot afford to do so, then the lender may choose to use your home to service or clear the debt.
Risk #4: Relationship Breakdown
With a divorce rate of 33%, there is the undeniable risk that in the event the borrower and their partner separate (whether or not married), a significant portion of the parents’ money may be lost to the child’s partner in a property settlement.
GIVEN THE SUBSTANTIAL RISKS OF BEING GUARANTOR HOW CAN YOU PROTECT YOUR ASSETS, WEALTH AND POTENTIAL FINANCIAL FUTURE WHEN GOING GUARANTOR?
Tip 1: Protect against the unexpected
Whilst no one likes to think about things going wrong, it is vital to have sufficient protection in case the unexpected occurs. Insurance cover including for both Income Protection and Total & Permanent Disability, will help to reduce the financial stress experienced during difficult times, and will also give both you and your child the confidence that no one’s home will be lost during this period.
Tip 2: Set a limit
Consider limiting your guarantee to a portion of the property price – say 20%. In most cases this will be enough to ensure your children can avoid lender’s mortgage insurance whilst also reducing the amount of damage that can be done to your finances in the event of a loan default.
Tip 3: Find your nearest exit
When establishing the guarantor loan it is prudent to also establish when and how your part in the loan will end. This could be a particular point in time at which your child will refinance and discharge the mortgage on your home. Doing this will not only serve as a reminder to your child that it’s your money and home involved, it will also (ideally) encourage them to pay the loan down and create equity for their own benefit as quickly as possible.
Tip 4: Seek independent advice
Being a guarantor calls for an unemotional assessment of your financial health as well as understanding your liabilities as a guarantor. Even though you are dealing with family, going guarantor should be treated as a business agreement. Before signing, seek legal and financial advice to ensure you fully understand this commitment and its impact on your current and future financial situation.
Tip 5: Objectively evaluate the borrower
It’s important to have a comprehensive understanding of the borrower and their financial mindset, as their actions will impact your financial future. Even though they are family, it is vital to take an objective look at whether they can afford to service the loan and whether they are fiscally responsible enough to focus on paying off the loan (or conversely, do they overspend and borrow to finance a “lifestyle”).
Tip 6: Buy property in the parents’ name or through a trust
To retain control, parents often prefer to keep the child’s property purchase in the parents’ name or that of a trust. However, at some point in time, the property will need to be transferred into the child’s name, whether on the death of the parents or if the title of the property is transferred to them. Although buying property in this way may protect your investment in case of a child’s relationship breakdown, there may be tax consequences when the house is transferred to the child either upon death or transfer of title.
Tip 7: Consider Other Options
You don’t have to guarantee your child’s home loan to help them. There are other options including:
- Gifting. You can choose to gift a deposit to help them qualify for a home loan without a guarantor. For example, some lenders allow borrowers to use one-off gifts to cover the cost of the deposit. This allows you to help your family member without taking on a long-term risk.
- A cash loan. Here a legally binding agreement is drawn up and signed by all parties. The agreement specifies the terms of the loan (e.g. any interest payable, how repayment will be made, deadlines etc). When drawing up the loan agreement, parents should keep a form of charge over the property, such as a mortgage or a caveat. Plus, the loan agreement or contract can also be the subject of a Binding Financial Agreement, which removes doubt over how an advance or a loan is to be treated if a child separates from his or her partner.
- Staying home. Allowing your child to stay at home for longer enables them to save money on rent, utilities and other expenses, helping them to save for a deposit at a much faster rate than would otherwise be possible.
Knowing the conditions of the guarantee is crucial
As a first point of call, you should know exactly what you are guaranteeing. Some important questions to ask are:
- Are you guaranteeing the whole loan amount?
- How much is the loan amount?
- Are you the only guarantor or are there others?
- Can the borrower increase the loan amount that you guarantee without you knowing or authorising?
- When will the lender pursue you? Is there a certain number of repayments that the borrower must miss before it is considered a default and the lender comes after the guarantor?
- How is the guarantee enforced? Lenders may register a mortgage over your property. If you already have a mortgage, this may be registered as a second-ranking (second priority) mortgage.
Whilst being a position to help a family member break into the property market may be exciting, you need to carefully consider the risks and responsibilities involved, understand the impact that will have on your financial situation (both now and potentially in the future) and examine whether it is the best option to pursue.
In order to do this, it is essential to get expert financial and legal advice before agreeing to guarantee a loan so that you fully understand the risks and can sufficiently protect your interests.
Once you know you’re protected, you can truly enjoy the journey of watching your loved ones work towards their own financial future.
If you have any queries regarding guarantor loans or would like to find out more, we’re here to help.