Guarantor loans: How they work
Get a foot in the market with a smaller deposit with a guarantor loan.
Imagine if you found the property of your dreams, but didn’t quite have enough of a deposit to secure it. But if you had a guarantor on-side, you could make it happen. So what is a guarantor and could they help you secure your first home, or borrow more?
How do guarantor loans work?
A guarantor loan works by the guarantor offering part of their home equity to top up your cash deposit; no actual cash transfer takes place in this scenario. With a guarantor, banks are willing to lend as much as 110% above the property value with competitive rates, without the requirement of Lenders Mortgage Insurance (LMI).
There are two different types of guarantor loans:
- Secured guarantee loans: This loan offers a little more protection to the guarantor in that it’s secured against the borrower's existing asset. This gives the guarantor a bit of leeway as banks will pursue that asset first before going for the guarantors’.
- Unsecured guarantee loans: This loan type is much riskier. It’s not secured against any asset of the borrower and in the case the borrower defaults on their mortgage repayments, banks will automatically seize the guarantor’s assets.
See how a guarantor loan works in practice. For example, you want to purchase a property worth $700,000. You currently have savings of $35,000 (being 5% of purchase price) and have sufficient income to service a loan of up to $700,000.
Normally, savings of at least $140,000 (being 20% of the property value) is required to obtain a loan and to avoid paying LMI. Given you need to borrow 95% of the property value, LMI will need to be paid on the loan on top of your usual mortgage repayments.
Your parents own a property worth $1,000,000. They offer $105,000 of equity in your home to the bank as security for your loan. You can now borrow $665,000 without paying LMI — thanks to a guarantee, you‘ll save $30,000 to $35,000 over the life of your loan.
There are a number of guarantor loan requirements. So make sure you talk to your lender about everything that’s involved in ensuring your eligibility for this type of loan.
Benefits of guarantor loans
The main benefit of guarantor loans is that it lowers the cost of entry for those with smaller deposits. Prospective homeowners could borrow the full amount of the loan without having to pay for Lenders Mortgage Insurance because lenders view guarantor loans as extremely low-risk. On top of that, many guarantor loans have very competitive interest rates.
Guarantor loans may also enable you to borrow more than the value of your home. Of course, this depends on the lender and the purpose of the loan:
- First home buyer: 105% of the property value
- Construction: 105% of property value
- Debt consolidation and purchase: 110% of the property value
- Investment: 105% of the investment property value
- Refinancing: 100% of the property value
As a guarantor, you can choose to limit the size of the guarantee in order to minimise your risk. This means you would only be liable for a certain portion of the loan, above which the lender assumes the risk. This allows flexibility and reduces strain for the guarantor.
Risks of guarantor loans
The main risk of guarantor loans is any default on part of the borrower would lead to banks taking possession of the guarantor’s property as the guarantor is legally obliged to repay the entire loan amount. This may involve selling the family home to service or clear it.
In this situation, the guarantor doesn’t have the right to demand that banks try to obtain payment from the borrower or to seize the borrower’s assets first; banks have ultimate discretion. However, in most cases, banks will take action against the borrower assets first before pursuing the guarantor.
Guarantors may also find it difficult to borrow again in the future, as their borrowing capacity will be restricted while the loan is outstanding. A Guarantor also does not have any rights to own the property they guarantee nor do they receive any credit rating improvement upon repayment of the loan.
Guarantor loan structure
There are a few ways a guarantor loan can be structured:
- Guarantee the whole loan: A guarantor can guarantee an entire loan, however, there is risk associated with this option.
- Guarantee 10% of the loan: A guarantor can provide a guarantee for only 10% of the loan to assist with avoiding LMI. This can occur through splitting a loan and providing a guarantee over only one of the split loans. The advantage of this is that the entire loan does not need to be repaid for a guarantor to be released.
- Guarantee then release: A guarantor can choose to be released from the loan once the borrower has enough equity to avoid paying LMO. For example, where the loan amount to property value ratio falls to 80% or below, a guarantor can exit with ease.
How do I become a guarantor?
It’s really important to understand all the conditions of a guarantor loan before entering into any arrangement. Rules towards guarantor loans are very tight and most lenders require the following:
- The guarantor should be employed and not on an aged pension.
- An investment property is preferred (not owner-occupied properties) as the property to be pledged.
- The property should be unencumbered or otherwise, an existing mortgage should be re-financed to the new lender. Second mortgages are typically unaccepted.
- The law guarantees your understanding by requiring you as a potential guarantor to obtain a solicitor’s certificate. This certificate essentially is proof that you understand the conditions and prevents you from relying on the lack of understanding as a means to escape your contractual obligations.
Apart from understanding the contractual conditions, you should also evaluate:
- Your relationship with the borrower
- The extent of your liability in the event of default
- Whether you can realistically afford to be a guarantor
- Whether the borrower can really afford the loan
Talk to your lender about whether being a guarantor is the right option for you.
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