Everything you need to know about Guarantor Loans
You may have heard a colleague or family member mention guarantor loans, but what are they? And who are they for?
What is a guarantor loan?
Well basically a guarantor loan uses the equity held in security, that is a home or investment property, owned by one person to guarantee a portion of another person’s loan. The guarantee is usually used to assist with covering part or all of the deposit for someone’s loan.
What could this look like?
Let’s take a young couple that are looking to purchase their first home for $500,000 who have been advised by their mortgage broker to apply for a loan at 80% Loan to Value Ratio (LVR) so they don’t need to pay Lenders Mortgage Insurance (LMI).
First things first lets break down LVR. The LVR represents the amount you are borrowing, as a percentage of the value of the property being used as security for the loan. LVR is always an important factor when applying for a loan, as the lower the LVR the less risk that the lender/bank is exposed to.
Conventionally speaking lenders will loan up to 80% LVR without incurring any excess costs or penalties to the borrower.
For example, let’s say that a young couple are looking to purchase a property for $500,000 and the loan they get is for $400,000.
The LVR of the home loan would be calculated like this:
($400,000 loan ÷ $500,000 property value) x 100 = 80% LVR.
Now that’s out of the way, let’s look more closely at the scenario.
Our young couple have been diligently saving for their deposit, as their mortgage broker has advised them to avoid the dreaded and costly Lenders Mortgage Insurance (LMI) which the broker has advised could cost them up to $17,500 if they wanted to secure a loan with the smallest allowable deposit of 5% deposit (95% LVR).
In order to achieve this they would need to save a 20% deposit of $100,000 that could take many years to accomplish.
“Isn’t there any alternative to get their loan without needing to save for the hefty deposit…?”
… Enter the guarantor loan
Following some further consultation, the broker discovers that the couple has parents who own a home outright. This means that the couple could ask the parents to act as guarantors for their loan.
*Note In order to act as guarantor person/s need to have sufficient equity to guarantee part or all of the deposit required by the borrowers for their purchase.
Provided that the parents are happy to proceed, what they are effectively saying as guarantors is they will guarantee the deposit for the loan with their security, and in the event of the young couple being unable to repay their loan, the bank would ultimately be able to approach the parents for the portion of the loan that they have guaranteed, in this case, the $100,000.
|Young Couple (Borrowers)||Parents (Guarantors)|
Home being purchased valued at $500,000
Own home outright valued at $700,000 (No existing mortgages)
Equity in home for used for guarantee
The result of the above guarantee is that the young couple requires no out of out-of-pocket funds for the deposit to secure the loan. Allowing them to get their loan much earlier and without the extra costs associated with LMI.
So who can be a guarantor?
Each lender will have their own specific policies regarding who they are willing to accept as a guarantor, but generally speaking, the guarantor will:
- Be aged between 18 and 65
- Have sufficient equity in their security to satisfy lender’s requirements, some lenders may require guarantors to own the security outright (No existing mortgages against property)
- Have a good credit rating
- Be an Australian citizen or permanent resident
- Be an immediate family member (lender policies vary)
Now before you go rushing off to your family to demand a guarantor it is important to know guarantor loans are not available to just any borrower.
Almost all lenders have policy restrictions that relate to guarantor loans, some require that borrowers do not own any other securities; other policies restrict the loans to first home buyers only.
So before setting your heart set on a guarantor loan, it is imperative that you seek advice from a specialised mortgage broker, this way you will know if a guarantor loan is right for you (and mum and dad!).
What’s the catch? Does a guarantor loan cost more?
Generally speaking, there are no penalty costs associated with a guarantor loan. Due to the deposit being guaranteed, the bank will usually view the loan as a conventional 80% lend, resulting in the borrowers having access to the most competitive products and rates offered by their lender.
Without the guarantee, the young couple would not only have to fund at least a 5% deposit, but also a lump sum for LMI. If that wasn’t bad enough lenders also apply higher interest rates to LMI loans due to the increased risk from their perspective.
Now the kids are asking you to be their guarantor – what do you need to know?
Becoming guarantor can be a daunting prospect at first, but it is important to remember that being a guarantor does not mean that you would be liable for the guarantee for the entire term of the loan.
In fact, the guarantee can be removed from the loan once the borrowers have sufficient equity in their home to satisfy the lenders LVR of 80%.
Consider our example, if the couple has purchased their home for $500,0000 with the 20% deposit guaranteed by their parents, the parents could be released as guarantors once the couple has either paid down the loan, meaning that they have a loan balance of $400,000. Alternatively, if the young couple’s home were to appreciate in value to a point at which the loan balance represents 80% of their home’s value, for example, the loan balance is $500,000 and the house appreciates to a market value of $625,000.
Is being a guarantor risky?
There is no way to avoid it, guarantor loans carry some inherent risk; if the borrowers for whatever reason are unable to meet their commitments to repay the mortgage then the bank can seek payment from the guarantors to cover the cost for the amount they have guaranteed.
This could result in the guarantors needing to take out a second mortgage against their home, or in an absolute worst-case scenario needing to sell their own home to cover the costs.
Acting as a guarantor can have an impact on your ability to secure any further loans whilst the guarantee is in place. For these reasons it is always recommended that the guarantors receive legal and financial advice before signing off on the guarantee, in fact, many lenders will require this as part of the application. It is always a great idea to consult with a specialist mortgage broker and or financial planner.
Points to remember when considering a guarantor loan
As a borrower, guarantor loans can be a great way to get your foot in the door to buy your first home. Because you do not need to save the full deposit amount you can avoid costly LMI and penalty interest rates.
Guarantor loans place risk on the guarantor, so it is important that you are upfront and communicate clearly with your guarantor, as they will need to fully understand your financial situation and the ramifications they may face if you don’t keep up your mortgage repayments.
As a guarantor, you may be able to provide a great opportunity to enable your children or close family members to achieve their dream of home-ownership in a cost-effective manner.
You are however exposed to risk, so it is imperative that you fully understand the financial situation of those whose loan you are guaranteeing, and maintain clear and direct communication until such time as you have been released as guarantor.