With the rise in housing prices and a relatively slow income growth, the capacity for some individuals to save an adequate deposit on a house or unit has become progressively difficult*. In light of this, to strengthen their loan application, some prospective new entrants may consider turning to family members for help via a loan guarantor arrangement.
Who may consider help from a guarantor?
Typically, an individual that requires a guarantor may not have an adequate deposit saved and/or a credit provider is concerned about his or her capacity to service a loan. Without a guarantor, it would mean that they may be required to pay Lender’s Mortgage Insurance^ or potentially have their loan application declined.
Depending on the circumstances and relevant credit provider, a guarantor may also be used for an investment or business loan.
What does it mean to be a guarantor?
A guarantor is someone who guarantees a loan for another person; however, the guarantor doesn’t have the right to own the property or items bought with the loan.
In some instances, for greater assurance, a credit provider may ask the guarantor, as part of their guarantee, to put up an asset as security; this is called a security guarantee. This means that the loan is secured using both the asset being purchased with the loan as well as the asset used as the security guarantee.
Depending on the circumstances, a security guarantee can either be in full or limited. Although full security guarantees do exist, it is common for credit providers to allow the guarantor to provide a limited guarantee for an amount sufficient to reduce the borrowing amount, for example, to less than 80% of the purchase price. This may help alleviate the need for Lenders Mortgage Insurance as well as reduce some of the risks and responsibilities for the guarantor.
Who can be a guarantor?
Guarantors can be immediate family members such as spouses, de facto partners, siblings, adult children or grandparents; however, in some instances, a credit provider may accept friends, workmates or associates.
Furthermore, a guarantor must be an Australian or New Zealand citizen, at least 18 years of age, of sound mind and generally must also be currently working; however, some credit providers may also accept self-funded retirees or recipients of social security payments such as the age pension.
In addition, if a guarantor intends to use their property as part of the security guarantee, certain criteria may need to be met. For example, the property can’t be located overseas and may need to be owned outright or owe less than 80% of the property value on an existing loan.
Important things to consider
Being a guarantor for a family member may help them enter the housing market with a smaller deposit (or, none at all), increase their borrowing capacity and potentially avoid the costs of Lenders Mortgage Insurance, but there are risks and responsibilities involved.
For example, if a family member defaults on their loan obligation then as the guarantor it becomes your legal responsibility (for the portion that you guaranteed). This responsibility might include the principal amount, any interest and default interest, as well as any fees incurred by the credit provider in resolving the default. Furthermore, if you are unable to service the loan, the credit provider may sell the asset that you put up as security to pay the outstanding debt.
So, before agreeing to be a guarantor on a loan do your homework.
1. Request a copy of the loan contract and take the time to understand:
- How much is the loan for, how much are the loan repayments, and what is the term (duration) of the loan?
- What is the interest rate on the loan, and is it an introductory rate that will revert to a higher standard rate after a given period?
- Is the family member putting up security for the loan, for example, their home?
- Will you be providing security as guarantor, for example, your home, and, what restrictions apply, if you decide in the future to sell the property?
- Will you be guaranteeing the entire loan amount or just a portion of it and for what timeframe?
- If the family member defaults on their loan repayments
- What are their responsibilities as well as yours as the guarantor?
- What are the actions that the credit provider may take to address the default?
2. Consider your relationship with the family member who is seeking loan approval. For example, a breakdown of the guarantor arrangement, due to a default arising, could place a strain on the relationship.
3. Evaluate your financial situation as well as that of the relevant family member. For example, if the person were suddenly unable to meet the required mortgage repayments for a period due to sickness or injury. Ask:
- Can you rely on your family member to repay the debt? Consider their current income and asset position as well as their future income and expenses. It’s important to be honest in answering this question as you will be putting your income and assets at risk by guaranteeing the loan.
- Do they have adequate personal insurance in place and what arrangements are in place to ensure the proceeds are used to repay the loan?
- Do you have the capacity to cover the loan obligation (for the portion that you guaranteed)?
4. Consider limiting your guarantee. For example, with the approval of the credit provider, you can limit the amount of the guarantee, as well as the timeframe in which the guarantee remains valid. This may help to reduce the risks and responsibilities involved in being a guarantor if a default was to occur.
5. If you are uncomfortable with the level of risk involved in being a guarantor, take the time to investigate other options. For example, consider the option of gifting or loaning the family member a portion of the required deposit. Before doing this, consider your cashflow needs and check the rules regarding gifting (if you're about to retire or are currently on Centrelink payments such as the age pension).
6. Finally, seek professional advice from your solicitor and financial adviser to make sure you fully understand what is involved in becoming a guarantor and how it may affect your financial situation. For example:
- Your intended asset distribution to beneficiaries via your Will may be impacted by a forced sale of the property you used a security.
- Your ability to borrow against your assets may be restricted if you are a guarantor (as the guarantee is recorded as debt).
- Your credit report may be affected if you are unable to service the loan obligations in the event of a default.
Being in a position to help a family member via a guarantor arrangement may bring a feeling of contentment. However, before making the commitment, carefully consider the risk and responsibilities involved, investigate other options available, understand how this may affect your financial situation, and seek professional advice.
*CoreLogic’s recent Housing Affordability Report (December 2016) highlighted that, ‘national dwelling prices have risen by 19% in the past five years, whilst household incomes have increased by 9.2%. In addition, the proportion of household income required for a 20% deposit on a home now stands at 138.9%’.
^Lenders mortgage insurance is a type of insurance, which lenders take out to cover the additional risk of high Loan to Value Ratio lending. Although this insurance covers the lender against the risk of you defaulting on your loan, the borrower pays the premium.