How Guarantor Loans Work, Plus An Alternative Option To Consider...
With the Sydney market cooling over the last few months, it seems that entry level prices are now at levels where first home buyers are once again interested in entering the market. Latest data from the abs has revealed that first home buyers now make up 18.3% of the mortgage market, which is the highest level since 2012.
Now for first home buyers, particularly in Sydney, having enough money for a deposit is always an issue. When savings are hard to come by, it means that you need to pay a considerable LMI fee or think outside the square. Increasingly, first home buyers in this position are solving this problem with the help of their parents via a guarantor loan.
Guarantor loans explained
For the record, I’m not the biggest fan of guarantor loans. Saving for your first property is hard work but also one of life’s greatest achievements, certainly from a wealth creation standpoint. It shows dedication and maturity and is a big step towards becoming a self-sufficient adult.
However, we’re all different and there are many circumstances in which it’s very difficult for a young adult to save for a deposit, so each to their own.
In any event, guarantor loans work by having your parents (or a relative) offer their property up as security, in addition to the property you’re looking to purchase.
For example, if you’re looking to purchase a $600,000 2-bedroom unit and your parent’s property is worth $1,200,000 the bank will take security over both properties, effectively increasing the overall asset base to $1,800,000.
Sticking to this example, let’s say that your parents have a loan with CBA for $400,000 and you’ve got absolutely no money for a deposit. Considering purchase costs for the 2-bedroom unit at 5% of the value of the property ($30,000), you could technically borrow from the bank the entire purchase price, plus costs ($630,000).
The reason for this is as the bank will be taking security over both properties, they’ll consider their overall risk position as $400,000 (parent’s loan) + $630,000 (your loan) = $1,030,00. Divided by $1,200,000 (parent’s property) + $600,000 (your property) = $1,800,000.
$1,030,000 / $1,800,000 = 57% LVR – a relatively low risk in their point of view.
Bank marketing games
The way in which a bank would structure this deal is to split your loan into two:
- Loan 1 - $480,000 (80% of the value of the $600,000 2-bedroom unit)
- Loan 2 - $150,000 (remaining balance)
What they’ll say is that loan 2 will be a ‘limited’ guarantor loan against your parent’s property.
The reason why they say ‘limited’ is because it would appear that you’re really only risking $150,000 instead of the full $630,000 so it’s not that big of a deal for your parents...
However, it should be noted that in the event of a default, the bank would still force you to sell your property to pay out loan 1. From there, you still owe $150,000 so if your parents can’t come up with the cash to pay out this loan then the bank reserves the right to sell their property as well.
As such, when it comes to ‘limited’ guarantor, just like Public Enemy would say, “don’t believe the hype!”
It’s important to note that if you want to go down the guarantor route, you’ll most likely have to go with the same lender that your parents are currently with as the bank needs to take security over both properties in order to de-risk their position.
In some cases, if your parents' loan is really low, you may have the option for the bank that you approach to take a second mortgage for loan 2 against their property. However, for a second mortgage, the bank that holds the existing one needs to grant permission for the second mortgage to be registered behind them. In most cases, the bank that holds the first mortgage wouldn’t allow this as for why would they agree to put themselves at potential risk?
Another option to consider
At the end of the day, a guarantor loan is essentially a private agreement between parents and their children for the parents. I’m sure all parents would agree that while they’re happy to help their children out, they don’t really want to risk their entire property in doing so.
As such, is for the parents to obtain an equity release loan for loan 2 (remember this is the smaller loan, $150,000 in our earlier example). From there they can either draw up a legal agreement with a solicitor which notes that the children need to pay back this loan with set terms or they can simply have a handshake agreement.
Yes, this loan will be in the parents' name and yes, the bank ultimately will hold them responsible for paying it back. However, it creates a clear line in the sand by not linking both properties together and is, therefore, a lower risk in opinion.