When buying a property, the general rule of thumb is that you should have a 20% deposit plus additional costs. Anything less than this may lead to lenders mortgage insurance (LMI) and higher interest rates. However, a 20% deposit is a significant amount, which can take years to save. Fortunately, there is an alternative: using a guarantor.
What is a Guarantor?
A guarantor is someone who offers assets as security for your loan. The person is typically a family member (often parents) and the security is usually their home, but some lenders also accept other assets like term deposits.
How much is the Guarantee?
The guarantee is generally the difference between your deposit and 20% of the property’s value.
For example, if you’re purchasing a $700,000 house with a $70,000 deposit plus costs, your loan-to-value ratio (LVR) is 90%. The guarantor would secure the additional 10% ($70,000).
Removing the Guarantor
Once your LVR drops to 80%, the guarantor can be released from the loan. This requires an application to the lender.
The LVR can reach 80% either by paying down your loan or through an increase in property value. Since property prices are out of your control, it is recommended to aggressively pay down the loan until you reach 80% LVR. The guarantor is taking a risk on your behalf, so it’s important to remove that risk as soon as possible.
What happens if You Don’t Meet Your Loan Obligations?
If you default on your loan, the lender will first work with you to explore options, such as capitalising interest for a short-term issue. If an agreement cannot be reached, the lender will seek to sell your property to recover the debt.
Should the sale of your home not fully repay the loan, the lender will turn to the guarantor for the shortfall. The guarantor can provide cash to cover the shortfall (up to the guarantee amount), but if they are unable to do so, the lender may sell the asset used as security. Any surplus from the sale would be returned to the guarantor.
Benefits of Having a Guarantor
For the borrower, having a guarantor provides several advantages:
- Smaller deposit required: You can buy a property with a smaller (or sometimes no) deposit.
- Avoid LMI: Lenders mortgage insurance can cost thousands, but with a guarantor, you avoid this cost.
- Better interest rates: Lenders view you as lower risk, offering more competitive interest rates.
- No need for genuine savings: Typically, lenders require you to show savings held for at least three months. With a guarantor, this requirement is waived.
Risks for the borrower
The primary risk for the borrower is that using a guarantor can allow you to borrow more money, increasing your repayments and further exposing you to interest rate fluctuations. Ensure that your cash flow can handle these repayments comfortably.
Risks for the Guarantor
The larger risk lies with the guarantor, and they should carefully consider the following:
- Asset at risk: If the borrower defaults, the guarantor’s asset used as security may be sold to cover the debt.
- Inability to sell the asset: Once an asset is used as security, it cannot be sold unless either a new asset is offered as collateral. If not, the borrower pays LMI to release the guarantor.
The Guided Investor approach
Utilising a guarantor can be a valuable financial strategy, particularly in Phase 1 of Wealth Creation when you are establishing your financial foundation. However, beyond this stage, it is advisable to become self-sufficient.
If you use a guarantor, it’s crucial to prioritise paying down your loan to release the guarantor as quickly as possible. This may mean cutting back on unnecessary luxuries. Additionally, ensuring you have adequate personal insurance is vital. This ensures that if you’re unable to work due to accident, illness or injury, you can still meet your loan obligations.
