Guarantor home loans
If your lender recommends a guarantor home loan to you, it’s important to fully understand what’s involved. It’s also important to fully understand what’s involved if you’re asked to be a guarantor for someone’s home loan.
This guide explains what both borrowers and guarantors need to understand before signing on the dotted line.
What is a guarantor home loan?
A guarantor home loan has an extra layer of protection for a lender compared to a standard home loan. This extra protection is provided by the guarantor, who provides a legal guarantee for the loan.
A home loan guarantor agrees to become legally responsible for repayments if the borrower defaults. ‘Default’ is a legal term meaning a failure to do something that’s required by law. In the loan context, a borrower defaults if they don’t make their contracted repayments.
Guarantors therefore lower the lender’s risk. It is up to the borrower to find a guarantor that is suitable to the lender. In other words, a guarantor that meets the lender’s criteria. Family members of borrowers are the most common guarantors. For example, the parents of first home buyers.
When do you need a guarantor home loan?
There are three common situations where you may need a guarantor when you apply for a home loan.
1) If you have a low deposit for your home.
The home loan approval criteria of different lender’s varies. However, if you have less than 20% deposit, you may be asked to provide a guarantor. The less deposit you have, the more risk there is for the lender.
A 20% deposit can be a hefty sum. The table below shows what it can be for a range of home values.
|Home value||20% deposit|
However, if you’re a first home buyer with a low deposit, you may be able to access government grants to help you. For example, the First Home Owner Grant or the First Home Loan Deposit Scheme. This assistance can help you avoid the need for a guarantor.
2) If you have a poor credit score.
When you apply for any loan, the lender will check your credit score. This score is compiled by credit reporting agencies in Australia.
You’ll have a poor credit score if you have failed to repay any loans or credit on time. Your lender will perceive you as a credit risk.
3) If you have no credit score.
If you have never had any loans or credit, you’ll have no credit score. For example, if you’re young and you’ve never borrowed before or had any phone or electricity accounts in your name.
How does a guarantor home loan work?
The home loan guarantor will usually provide extra security to the lender by providing one of the following.
1) An income guarantee
The guarantor satisfies the lender that they have the income and financial position to afford the borrower’s repayments.
You can use our calculator to work out repayments on different loan amounts with different interest rates and terms.
2) Collateral security
Collateral security is a financial term. It involves offering assets as lender security for approving a loan.
If the borrower fails to make repayments, the lender can legally repossess the guarantor’s collateral security asset. The lender can then sell the asset to recoup any amount owing on the home loan.
The preferred collateral security on a guarantor home loan is property. Guarantors therefore need to own their home or have enough equity in it to satisfy the lender’s collateral security requirements.
Each of these two guarantees (income and collateral security) reduces the lender’s risk on a guarantor home loan.
Do guarantor home loans cost more?
Home loan interest rates vary between lenders, so it’s important to do your market research. If you don’t have time, you can get a licensed mortgage broker to do it for you.
Many guarantor home loans have the same rates as standard home loans because the lender’s risk is the same. A suitable guarantor lowers the lender’s risk.
A guarantor home loan could in some cases be cheaper because it can avoid the need for lenders’ mortgage insurance (LMI). Lenders will usually require a borrower who has less than 20% deposit and no guarantor to pay for LMI. However, the income guarantee or collateral security provided by a guarantor can make LMI unnecessary.
How long does a guarantor arrangement need to last?
The guarantor home loan arrangement only needs to last until the borrower satisfies the lender’s standard home loan criteria. For example, until the borrower:
Sufficiently lowers their loan-to-value ratio (LVR).
The LVR is the amount owing expressed as a percentage of the home’s value. For example, if there is $600,000 owing and a home is worth $700,000, the LVR is 85.7%. This figure is calculated by dividing $600,000 by $700,000 and multiplying by 100 to convert the ratio to a percentage.
Borrowers can reduce their LVR over time in two ways:
1) by making loan repayments.
2) via their home increasing in value.
Most lenders will be prepared to convert a guarantor home loan to a standard home loan once the LVR falls below 80%.
Develops a good credit score.
Borrowers can develop a good credit score by making all their debt and credit repayments on time. They can also improve it by not applying for any more loans or credit.
The pros and cons of guarantor home loans
The benefits and risks of guarantor home loans
Get their loan approved
A guarantor could be the difference between a loan application being approved or rejected.
Get the best possible terms and conditions
Guarantors lower lender risk, which can mean lower interest rates, no need for LMI, and/or lower home loan fees. All of those things translate into cost savings for borrowers.
Enter the property market sooner
It can be difficult for some borrowers to meet a lender’s standard home loan criteria. By the time they do, property prices may have increased.
Australian property prices have a long-term record of growth. Sydney and Melbourne property markets are also among the most expensive in the world, which is a barrier to entry.
Again, this is because of the additional security provided by the guarantor. Borrowing more can enable you to buy a better property.
However, it’s important to understand that the more you borrow, the more interest you’ll pay. Your regular repayments will also be higher if you borrow more.
The potential to damage family relationships
In the worst-case scenario, the lender becomes legally liable for the borrower’s home loan debt. This financial burden can destroy family relationships. A guarantor arrangement should not be entered into lightly by either party.
Reducing the guarantor’s borrowing capacity
While the arrangement is in place, the guarantor won’t be able to borrow as much themselves if they need to. The guarantor’s legal commitment to the borrower will be factored into any loan or credit application.
Depending on the extent of the guarantee or the security provided, they may not be able to borrow at all.
The potential to damage the guarantor’s credit score
If the guarantor has provided an income guarantee and doesn’t make the defaulting borrower’s repayments, their credit score will reduce. This will hurt the guarantor’s chances of borrowing money in the future.
Tips for consider before taking up guarantor home loans
You’ll reduce your risk if you take care of these fundamentals.
A guarantor home loan is a big commitment for both the borrower and guarantor. Both parties should get independent legal and financial advice before entering into any arrangement.
This advice should help to ensure that they each understand the implications of their arrangement. It should also determine whether the arrangement is appropriate for their respective financial circumstances.
This is important for both the borrower and the guarantor. Both need to be prepared for the consequences in the worst-case scenario.
Guarantor arrangements can ruin family relationships if the guarantor becomes legally responsible for the borrower’s home loan. They can lose some of their own assets or a significant portion of their income to cover the debt.
It’s important to discuss what could happen in the worst-case scenario before a guarantor home loan is put in place.
The lender may only require a guarantor for a portion of the loan (e.g. 20%), not the full amount. This will lower the guarantor’s exposure if the borrower defaults on their repayments. They will only be legally liable for a lower amount.
From the guarantor’s perspective, it’s better to avoid putting up their family home as security. An investment property should be used instead if one is available. This ensures that the guarantor isn’t at risk of losing their residential home.
Make sure that there is a documented exit strategy for when the guarantor arrangement will end. For example, when the LVR is below 80% or when the borrower’s credit score improves. Ideally, this should happen within a few years so the guarantor can be removed. The borrower can “stand on their own two feet”.