Helping your family member access a home loan by playing guarantor could enable them to enter the property market sooner. At the same time, it's not a decision to be taken lightly. You could be ultimately liable for the entire loan amount or a portion of the loan repayments if things go wrong.
Sometimes, guarantors can feel a severe strain on personal finances or relationships when things haven't gone to plan.
If you're planning to go guarantor, get ahead of any problems by reading over this list of things to know before you commit to the deal.
What is a Guarantor on a Loan?
Sometimes a person may choose to help a family member step on the property ladder by becoming the guarantor for their home loan. Generally speaking, a guarantor on a home loan will typically leverage the equity in their home as security for the loan being applied.
So, if you're a guarantor, it means that the home buyer will use your existing property as additional collateral to access a home loan instead of showing a house deposit amount.
In sum, by becoming a guarantor, you are committing to the loan provider that the borrower (whom you are standing as a guarantee for) will honour the loan contract. Furthermore, being a guarantor on a loan also implies that if the borrower defaults and cannot make the repayments, you’ll repay the loan for them as per the contract.
How Does a Guarantor Help a Home Loan Application?
Many young first-time borrowers find it easier to buy property sooner with some help from parents and grandparents going guarantors for the following reasons.
1. Helps Avoid Lenders Mortgage Insurance
Where borrowers - especially first home buyers - are eager to buy a home, not being able to show a 20% deposit can affect their chances of getting approved.
If the buyer does not have the required deposit, they have to pay Lenders Mortgage Insurance (LMI), which can cost a few thousand dollars. Alternatively, they may have to postpone the decision to purchase a home.
In most guarantor home loans, the guarantor's equity must cover 20 per cent of the newly purchased property’s value. This helps home buyers avoid paying LMI and improves their chances of getting approved.
2. Increases Borrowing Power
Backed by a guarantor, home loan applicants can now borrow up to 100% - 105% of the property’s purchase price without showing the deposit.
This is because:
- Up to 20% of the loan can be secured on the guarantor's property.
- Therefore, 80% of the loan amount will be secured on the value of the property being purchased.
3. Better Interest Rates
The LVR (Loan to Value Ratio) refers to the ratio of the loan amount compared to the new property value. Where LVR is too high (above 80%), borrowers may have to pay LMI or, in some cases, not qualify for a home loan.
It's common knowledge that some of the best home loan rates are available to borrowers with an LVR of 80% or less. But, again, guarantors play a significant role here. Alongside helping first-time home buyers avoid paying LMI, they also enable them to borrow funds at better interest rates.
4. Additional Security
When assessing home loan applications, every credit provider conducts minute checks to understand if they will be able to recover the money lent.
Along with LMI, other buying costs, including stamp duty, lender fees, mortgage insurance, and additional ongoing fees, push up the costs of buying a new home. With a guarantor home loan, lenders have greater assurance that in case the borrower cannot make the mortgage repayments, the guarantor may be legally responsible for paying the loan back.
Who Can Be a Guarantor on a Mortgage?
The lending criteria of different banks and lenders vary regarding who can act as a guarantor.
Usually, a family member or legal guardian over the age of 18 can step in as a guarantor. If you're a parent, you can be a guarantor, but you could also be either of the following:
- Grandparent and legal guardian
- Adult child
- Spouse/De-facto partner
Some lenders may permit extended family members, including aunts, uncles, and other relatives, to be loan guarantors. But as stated earlier, these are subject to individual lending policies.
Likewise, in most cases, friends, coworkers, former spouses/partners, and those with poor credit reports are not allowed to become guarantors.
How Does Going Guarantor on a Home Loan Work?
Guarantor loans have become rather popular in recent years as they enable home buyers to purchase their own property earlier.
Here are some key highlights of how a guarantor home loan works. It'll help you proceed in an informed manner:
1. Choosing the security: As a guarantor, you'll have to select an asset that you're using as security. So, for example, if you select your home equity (as most do), you'll need to demonstrate sufficient equity in your existing home, which can be used as a security guarantee for the guarantor loan. Some lenders may accept a Term Deposit as security. Once approved, the applicant's loan will be secured by the guarantor's property/asset and the new property being purchased.
2. Limited or unlimited guarantee: Depending on the guarantor’s consent and the lending criteria, the loan may be:
- Limited guarantee: Since the borrower does not have to show a house deposit - thanks to the guarantor's security - many lenders now allow the option of a limited guarantee. The guarantor's exposure is reduced to only part of the mortgage.
- Unlimited guarantee: If required, the lender can claim up to the entire debt owed from the guarantor's security property. This loan type is neither common nor recommended. Some lenders have set capped the percentage of the loan that a guarantor can provide. For example, a single guarantee may represent only up to 50% of the guarantor’s security.
3. Recovery: If the borrower renegades on the loan repayments, the lender has the full right to sell the property and recover the money. Where the sale price cannot recover the outstanding loan balance, the lender can seek the limited guarantee amount from the guarantor.
4. Duration: Notably, as a guarantor, you don't have to continue on the loan for its full term. You can be released once your guaranteed part has been repaid.
Example of a Limited Guarantor Home Loan
Lisa wants to purchase a property worth $600,000. Her mortgage broker has determined that her stable income is capable of servicing the loan.
She has to show the bank a 20% deposit ($120,000) to avoid the LMI payment. However, her own savings are only $20,000 to date.
Lisa's father offers to go guarantor. His own home is valued at $950,000, and he provides her $100,000 of his home equity as security for a guarantor loan. This helps Lisa show the required 20% deposit.
Consider the Following Scenarios Regarding Loan Repayments:
- Lisa makes her monthly repayments regularly: In this scenario, once Lisa's equity in her new home touches 20%, she and her father apply to their lender to release her father from his obligations and remove his guarantee.
- Lisa defaults on her loan: In such a situation, Lisa's lender exercised the right to sell Lisa's home and recover the loan. However, if the lender's sale price does not cover the outstanding loan amount, the lender can legally seek the guarantee amount from Lisa's father. In this case, the father may need to put out up to $100,000 to repay the guarantee amount. Repossession usually occurs only if the mortgage has been outstanding for 90-180 days.
- Lisa defaults, the funds from the sale of her house are insufficient, and Lisa's father cannot repay the limited guarantee: Now, the lender has the legal right to sell the father's property to recover the guarantee amount, i.e., $100,000.
What Does a Guarantor Need to Provide for a Loan?
As a guarantor, you'll need to provide your property as security to enable the applicant to qualify for a guarantor loan.
In most cases, the amount of security you'll be required to provide is around 20% - 25% of the purchase price of the new property. However, this may be lowered if the primary applicant can show a part of the deposit and minimises the amount of guarantee expected from you.
What Checks Are Done on a Guarantor?
Bank and credit representatives are keen to understand your overall financial situation as a guarantor. So they'll typically run checks, including:
1. Guarantor's Credit Report and Income
In addition, to the home equity, you'll typically need to provide evidence of a good credit score.
Some home loan specialists may even review the guarantor’s income. In contrast, some lenders may NOT factor in the guarantor's income when assessing this type of loan. Eventually, it all depends on each lender's requirements.
Overall, these checks ensure that even as a guarantor, you are not a high-risk case and will be able to make repayments if the primary borrower defaults on the mortgage repayments.
2. Second mortgage
If you're a potential guarantor, the bank will also want to know if you have existing debts. Nonetheless, if your home has a loan, as long as you have sufficient equity, some home loan specialists may be willing to use a second mortgage and secure a guarantee on your property.
Be sure to declare all loans secured on your property. Else, the approvals may be withdrawn at the final moment.
At the same time, your original lender with a home loan secured on your property will need to consent to the new guarantee being secured on your property. Therefore, there could be a slight possibility that they may withhold or deny consent, leaving you unable to stand as a guarantor.
For this reason, do not commit to any obligations until the consent for your second mortgage has been granted, the bank's valuation of your guarantor property is finalised, and the credit provider has issued a formal approval.
What Are the Risks of Being a Guarantor?
If you're actively considering guaranteeing a loan for your family, you should observe the same caution as if you were to out a loan for yourself.
As much as you'd like to help, you should be aware of potential risks, including the following:
Strain on Relationships
If you've chosen to be a guarantor for a family member and that person cannot pay back the loan due to personal circumstances, it could cause lasting damage to your relationship.
So, if you don't feel comfortable going guarantor a loan, it may be better to express your concerns at the start. Likewise, don't let yourself be coerced into becoming a guarantor. It may be better for both parties if you can help out financially in other ways.
Repaying the Debt in Full
Suppose you’re a guarantor, and the borrower is not in a position to meet the home loan repayments. In that case, where your guarantee is not limited, you’ll most likely have to pay back the entire loan amount and interest.
If you cannot make the repayments, the lender could exercise the right to sell your home if it was provided as security for the loan.
Possibility of Being Unable to get a Loan for Yourself
If you must apply for a loan at some time in the near future, you'll need to disclose to potential lenders if you're a guarantor on any other loans. There's a fair chance that you may not be allowed to access a loan, even if the loan where you're a guarantor is being repaid regularly and on time.
Your Credit Report may be Adversely Affected
Being a guarantor could affect your credit score if you or the borrower do not pay back the guaranteed loan. You could be listed as a defaulter on your credit report, making it challenging to get approved for a loan in the future.
As you may have realised, it's essential that, as a guarantor, you have the utmost clarity on the loan contract and your obligations before signing. Therefore, it's a good idea to seek legal and financial advice before entering any guarantee agreement.
Can You Sell Your House if You Are a Guarantor?
You may be unable to sell your property, borrow and/or make top-ups on your mortgage by becoming a guarantor.
You may have to consider other options if you have to sell your property.
Where borrowers owe more than 90% LVR, they would need to come up with their own savings to cover the difference so that you(a guarantor) can sell your house.
For example, if your guarantee was for $90,000, the borrower will need to offer the lender a $90,000 term deposit, which can be held as security.
How to Withdraw From Being a Guarantor
Usually, you cannot be a guarantor until the borrower has built up equity of at least 10% or 20% in the loan to avoid paying LMI. Alternatively, the borrower should be ready to pay the LMI and remove the Guarantor if the LVR is still above 80%. This is, however, subject to lender requirements.
In some cases, depending on the contract, to be released from your role and responsibilities as guarantor, the borrower will need to either need to pay off the loan entirely.
The primary borrower may need to refinance when you withdraw from the contract. Since this cannot take place automatically, the lender will review the borrower's financial situation again during the refinancing process.
Therefore before becoming a guarantor, you must consider your decision thoroughly before your borrower receives the home loan approval and signs the Contract of Sale.
Final Considerations Before Going Guarantor
If you decide to go ahead and become a guarantor, you should consider your personal objectives and other factors to ensure your financial well-being. Here are our top suggestions:
1. Loan Amount
Before committing, check if you'll be able to meet the loan repayments in case the borrower cannot. Next, you should calculate how much you'll have to pay back. Then, consider the loan amount, interest, fees, and other charges.
If you're a guarantor for the entire loan amount, you'll be obligated to pay the loan amount and all the interest if the buyer defaults.
Overall, it's safer for you to guarantee a fixed amount only. This lets you know exactly how much you may have to repay.
Ask yourself if you are honestly comfortable using an asset like your house as security. If the borrower defaults, the lender will require your to sell your home and repay the debt.
3. Loan term
If borrowers take a longer loan term, they will have to pay more interest. As a potential guarantor, beware of guaranteeing loans that don't have a specific end date.
Your Relationship with the Borrower
Generally, the closer your relationship with the borrower you're guarantor for, you'll have a better chance of recovering your money if things go wrong. Avoid standing in for distant relatives as far as possible.
Get Personal Financial Advice
You should ideally speak with a finance expert and obtain independent legal and financial advice. This will help you understand how your guarantor role will affect your financial situation.
Being a guarantor comes with a lot of risks and legal obligations. Further, you may want to help your child without putting yourself at risk and yet be able to live as per your retirement plans.
You could consider gifting them money or an advance inheritance which they could use to show a deposit.
Alternatively, you could suggest the First Home Guarantee Scheme (FHBG) and other first home buyer grants by the federal government and states. The FHBG enables eligible first home buyers to purchase a home with a deposit of as low as 5 per cent—the government steps in as the guarantor for the remaining deposit amount.
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