What is a guarantor loan?
A guarantor is a third party to a home loan (typically a parent or a spouse) who allows the equity in their own property to be used as additional security for a borrower’s loan.
A guarantee involves a family member of the borrower promising to repay a loan in the event of the borrower defaulting on the loan. This is done by pledging a property as security on the loan.
During the guarantee period, the guarantor is liable to meet home loan repayments if the borrower defaulted. Otherwise, the lender may foreclose on the guarantor and/or borrower’s property to recoup losses.
When should you use a guarantor?
Using a guarantor is another way to help a borrower get into the property market assuming he/she is able to repay the loan. Having a guarantor is useful for borrowers who do not want to pay mortgage insurance (Lender’s Mortgage Insurance or LMI) or lack genuine savings to meet lender requirement for a loan.
Where a borrower wants to borrow more than 80% of a standard loan (i.e. the borrower does not have a 20% deposit saved), the banks will require a borrower to pay an additional amount of insurance on top of the usual repayments. This is referred to as LMI and typically costs thousands over the lifetime of a loan. With many struggling to scrape together enough funds for a 20% deposit, first-time buyers could end up having to pay more than they realise.
However, the presence of a guarantor will allow a lender to maximise their borrowing power to borrow. This is best illustrated with an example (ignoring stamp duty and transaction costs):
- Your daughter wants to purchase a property worth $700,000. She currently has savings of $35,000 (being 5% of purchase price) and has sufficient income to service a loan of up to $700,000.
- Normally, savings of at least $140,000 (being 20% of the property value) is required to obtain a loan and to avoid paying LMI. Given your daughter needs to borrow 95% of the property value, LMI will need to be paid on the loan on top of her usual mortgage repayments.
- You own a property worth $1,000,000. As a loving (and generous!) parent, you offer $105,000 of equity in your home to the bank as security for your daughter’s loan.
- Your daughter can now borrow $665,000 without paying LMI. This represents a $30,000 to $35,000 savings from avoiding LMI payments over the life of a loan.
Other loan structure considerations
A guarantor does not need to guarantee an entire loan amount. Rather, a guarantor can choose to be released once the borrower has sufficient equity (for example, where the loan amount to property value ratio falls to 80% or below).
Alternatively, a guarantor can provide a guarantee for only 10% of the loan to assist with avoiding LMI. This can occur through splitting a loan and providing a guarantee over only one of the split loans. The advantage of this is that the entire loan does not need to be repaid for a guarantor to be released.
Taking the earlier example:
- Your daughter can choose to obtain two loans – one for $560,000 and another for $105,000 (totalling $665,000 in borrowings) to purchase her property.
- Rather than providing a guarantee over the entire $665,000 loan, you can provide a guarantee over the $105,000 loan amount only. You would not be responsible for the $560,000 loan (your daughter should be grown up enough to handle this one!).
- Where a guarantee is provided over the $105,000 loan amount only, you would only be responsible for your daughter repaying this smaller loan. Upon repayment of the smaller loan by your daughter, you would be released from any further guarantor obligations.
What are the risks if you are a guarantor?
Lenders typically require a guarantor to seek and obtain independent legal advice prior to signing a guarantor document.
Serious thought needs to be given before signing on a guarantee. Loans secured in this manner may result in serious financial repercussions for a guarantor, especially where the loan is secured against a family home.
There are no direct financial rewards for becoming a guarantor - there is only risk for the following reasons:
- Where something goes wrong during the life of the loan (which may be a 25 or 30-year loan), the guarantor is legally obliged to repay the entire loan amount. This may involve selling the family home to service or clear it.
- The ability for the guarantor to borrow again in the future will be restricted whilst the loan is outstanding.
- The guarantor has no rights to own the property purchased with the loan.
- There is no credit rating improvement upon repayment of the loan.
Given the gravity and degree of risk involved, a guarantor needs to be completely confident and assured that the borrower can repay the loan (keeping in mind that illness or loss of a job by the borrower may affect the ability to repay the loan). For this reason, it is very important that a guarantor is not pressured into providing a guarantee where there are any doubts.
Being a guarantor is not the only way you can help your children or family member in their property purchase. Other options may include providing a one-off gift payment to cover a deposit which may reduce ongoing risk and responsibility for you.
Can I be a guarantor?
Rules towards guarantor loans are very tight and most lenders require the following:
- The guarantor should be employed and not on an aged pension.
- An investment property is preferred (not owner-occupied properties) as the property to be pledged.
- The property should be unencumbered or otherwise, an existing mortgage should be re-financed to the new lender. Second mortgages are typically unaccepted.