What is a guarantor loan and how does it work?

Buying a home can be challenging, especially when saving for a deposit feels like an uphill battle. For many Australians, a guarantor loan offers a pathway to homeownership sooner by leveraging the support of a trusted family member or close relative.

According to research by Digital Finance Analytics, the percentage of first homebuyers seeking help from parents jumped from 3 per cent in 2010 to 59 per cent, with the average loan for a deposit increasing from $23,000 to $107,000.

Here’s what you need to know about guarantor loans and how they work before diving in.

What is a Guarantor Loan?

To buy a property, you usually need a 20 per cent deposit. For many people, saving a deposit of that size can be difficult and take years, particularly with today’s cost-of-living pressures.

A guarantor loan allows you to purchase property with the financial backing of a guarantor, usually a parent or close family member. The guarantor uses their property’s equity as security for part of your loan, helping you reduce or eliminate the need for a deposit. Thus a guarantor loan offers an alternative way to get into the property market. Sometimes, a guarantor can mean being able to purchase a home with no deposit at all.

This arrangement can also help you avoid paying Lender’s Mortgage Insurance (LMI), which is typically required for loans exceeding 80% of the property’s value. It’s to cover the lender against the risk of you defaulting on the loan.

Who can be a guarantor?

Typically, a guarantor is a close relative like a parent, grandparent or sibling who is willing to offer up their own home equity in addition to your cash deposit.

If you’re unsure what equity is, it’s the difference between their property’s value and how much they (still) owe on it.

How does a guarantor loan work?

1. Loan Security Structure
   The guarantor pledges a portion of their home’s equity, which acts as additional security for your home loan. For example, if you’re borrowing 100% of your property’s purchase price, the guarantor may secure up to 20% of the loan.
2. Two Separate Mortgages
   A guarantor’s property remains their own, but the lender will place a second mortgage on it for the guaranteed portion. This second mortgage is separate from their existing home loan (if any).
3. Limited Guarantee Options
   Guarantors can often limit the amount they’re guaranteeing, reducing their financial exposure. Once your loan balance reduces or your property value grows, you may be able to release the guarantor from their obligation.
4. Repayment Responsibility
   As the borrower, you are responsible for all repayments. The guarantor only becomes liable if you default on the loan.

EXAMPLE:-

Say you wish to buy a $600,000 property and you have a 10 per cent deposit saved of $60,000. To buy the property, you need a deposit of 20 per cent, so $120,000, otherwise, you’ll have to pay LMI.

Your parents offer $60,000 of their home equity as extra security for your home loan. They don’t have to make any payments at settlement, but if you default on your mortgage repayments down the track, the guarantor may be liable.

Once you’ve built up equity in your home – either by paying down the mortgage or if the value of the property increases – your guarantor can be released from the loan (fees may apply).

Benefits of a Guarantor Loan

1. Buy Sooner: With the deposit hurdle removed, you can fast-track your property purchase.
2. Avoid LMI: Save thousands of dollars in insurance premiums.
3. Potentially Better Interest Rates: Increased security for the lender can mean more competitive rates.
4. Preserve Savings: Keep your funds for other purposes, such as moving costs or home improvements.

Risks for the Guarantor

1. Financial Liability: If you default on the loan, the guarantor must cover the guaranteed portion, potentially leading to the sale of their property if they cannot repay the amount.
2. Impact on Borrowing Power: The guarantor’s ability to take on new loans may be reduced while the guarantee is in place.
3. Emotional Stress: Entering a guarantor arrangement is a significant commitment that requires careful consideration and open communication.
4. Mixing Family and Finances: Combining family relationships with financial obligations can create tension or strain, especially if unforeseen financial difficulties arise. It’s important to set clear expectations and boundaries before proceeding.

It’s a good idea to seek legal and financial advice before entering into a guarantor home loan.

Key Considerations Before Proceeding

1. Legal Advice: Guarantors should seek independent legal advice to fully understand their obligations.
2. Financial Health Check: Ensure both the borrower and guarantor have the financial stability to manage potential risks.
3. Exit Strategy: Plan how and when the guarantor will be released from their guarantee.
4. Eligibility Criteria: Lenders may have specific requirements, such as the type of relationship between borrower and guarantor and the guarantor’s property value.

Alternative Options

If a guarantor loan isn’t the right fit, consider:

• Saving for a Larger Deposit
• First Home Owner Grant Schemes
• Shared Equity Programs
• Exploring Lower Deposit Loans (with LMI)

A guarantor loan can be a powerful tool for aspiring homeowners, but it’s not a decision to take lightly. Whether you’re the borrower or the guarantor, understanding the responsibilities, risks, and rewards is crucial to making an informed choice.

Considering a guarantor loan? Let us guide you through the process. Get in touch today and we’ll run through the pros and cons of a guarantor loan and the different lender requirements.

 

Disclaimer: This blog offers general information on mortgages and finance for informational purposes only. It is not a substitute for personalized advice from a qualified mortgage professional or financial advisor. Use your discretion and seek professional guidance based on your individual circumstances.