How guarantees work

With housing affordability and the difficulty to enter the property market becoming a greater focus for first home buyers and investors – the topic of guarantor loans is now coming to the forefront as a solution. Guarantor home loans allow people to buy properties without the major hurdle – saving their deposit – bringing forward the time they can make their first purchase as well as avoid costly fees such as Lenders Mortgage Insurance which would otherwise be payable without a 20% deposit.

What is a Guarantee and how does it work?

Guarantees are specific type of loan product/policy which is put in place to assist those with low/no deposits available to be able to purchase a property with the assistance of another party who has sufficient equity in a property (or a term deposit with some lenders) to ‘guarantee’ their purchase until their property has sufficient equity to have said guarantee removed.

Instead of providing the traditional deposit through cash/savings or borrowed funds released from the equity of another property, the equity of the guarantor property is used as ‘security’ to protect the interests of the bank should the loan be called in due to bankruptcy etc.

This means that the borrower can then potentially make a purchase with effectively no deposit and have the entire borrowing costs (stamp duty, government charges) capitalised onto the loan. Keep in mind that every lender has a different policy/set of rules with guarantors (and some do not allow guarantors at all), so what is allowable is dependent on the lender being used.

Once the loan is setup, the borrower pays the loan as they would a standard home loan – the guarantor is not required to make repayments on the loan.

Generally the bank that the guarantor is using for the mortgage on the property providing the guarantee needs to be the same lender used for the guarantor purchase (if they have a mortgage on the property), however in circumstances where it’s not possible for the purchaser to use this lender some lenders will be able to provide a ‘second mortgage’ – allowing the purchaser to use a different lender. This can cause a longer delay in the finance/settlement process and have larger fees to setup.

What are the benefits?

The benefits are obvious with guarantor loans – it allows borrowers to purchase a property with zero deposit, bringing forward the time it would take them to buy a property, so they can get into the market sooner, stop paying rent, buy instead of sitting through a rising market etc. Through purchasing via a guarantor, no lenders mortgage insurance (LMI) is charged which for first home buyers in particular can equate to 10’s of thousands of dollars saved from day 1.

What it looks like: Example

Sally is a first home buyer whose parents are providing a guarantee so she can purchase her first home sooner, with no deposit. The figures are as follows:

Property Being Purchased: $400,000

Guarantor (Parents) Property Value: $500,000

Parents Existing Loan: $200,000

Stamp Duty and other Government Charges: $19,520

Total loan required: $419,520 (purchase price + government charges)

Total amount required to be guaranteed: $99,520 (20% of purchase price + government charges)

Lenders will require the parents to maintain at least 20% equity in their home after covering their existing loans and any guarantor amount – which in this case would mean a maximum of $400,000 in loans secured against their $500,000 house. As their existing loan is only $200,000 and guarantor amount $99,520, they have more than sufficient equity to help Sally buy her first home.

Every lender is different with their specific policy on how much equity can be used for guarantees, how much equity must be left in reserve and who can qualify for a guarantee, so make sure you have your specific situation reviewed to ensure the best lender is used for your scenario.

Is this risky for parents?

Parents providing guarantees are liable up to the maximum of the guarantee amount (generally 20%+ stamp duty/government charges). Should the borrower receiving the guarantee have their property foreclosed and the bank is unable to recoup all costs from selling the property, the guarantors would then need to make up the short fall.

Statistically the primary reasons for this is medical issues and loss of income – which can be mitigated through ensuring appropriate protections are put in place to not only protect the guarantors from this risk, but also the purchaser so they do not have their most value asset at risk.

How to mitigate risks

To protect the borrower and people providing guarantee, always ensure you’re appropriately protected with life, income, TPD, trauma insurances etc.

Accelerating the repayment of your loan through early repayments or higher repayments set from day 1 can bring the date at which the guarantee can be removed ahead, reducing the window in where the guarantor can be seen as having a ‘risk’.

Removing the guarantee

Removing a guarantee is relatively simple – if the debt is paid down to have the property paid down to an 80% loan to value ratio (LVR), property value increase that the debt is now 80% LVR OR a combination of the two, the lender will allow the guarantee to be removed – generally after verifying the new equity position via a valuation.

Alternatively when the property has a 90% LVR, the guarantee can be removed and lenders mortgage insurance fee is put onto the loan through an internal refinance.

Through prudent planning from day 1, it can potentially be possible to use a guarantee to enter the property market and then remove the guarantee within 12-24 months.

Tip – Guarantees can also be used for investment

A number of lenders will allow guarantees for borrowers to purchase investment properties. This can allow you to build your portfolio sooner and redirect your funds for other purposes such as renovation funds. Add this type of finance strategy with a renovation/revaluation strategy can be a potent mix which can assist early investors build their equity position from a small deposit basis.

Instead of putting finite funds towards the initial deposit, these funds are instead kept in reserve for the renovation funds on a property with short term equity growth potential post renovation. Once the renovation is completed, the property can then be revalued and equity position re-assessed. Should the value have increased sufficiently, the guarantee can be released.

Is this possible for me?

Guarantor home loans are a non-general type of lending and have very specific policy requirements which differ per person and their scenario. This can vary between the type of people who are allowed to provide guarantees, the age of the borrowers/guarantors, maximum guarantee amounts etc. To find out whether a guarantor home loan may be possible for your circumstances, contact your finance strategist who will be able to guide you through the options.