by Rob Stock (Sunday Star Times)
Reserve Bank restrictions on banks’ low-deposit home loans has seen a rise in equity-rich parents providing guarantees to help their kids get a home loan. The restrictions brought in late last year were designed to slow Banks lending to people with less than a 20 percent deposit and hence stop Banks’ balance sheets getting too risky.
As a result personal guarantees have become an important mechanism for people to get into a house when they only have a small deposit as they provide a way around the Reserve Bank rules. However care needs to be taken when setting up such guarantees to minimise how long the guarantee is in place and how much it covers.
Most independent people in their thirties react with horror when it’s suggested to them that their parents should guarantee their loans, until they hear how much it can save them. A couple wanting to buy a $600,000 home who only have a $50,000 deposit may be able to persuade a Bank to lend to them but it will come at a price. They could end up paying around 100 basis points more for their loan than people with loan to value ratios (LVR) of under 80 percent. That’s a lot of additional cost over a long term mortgage. But if a parent with equity was willing to guarantee say $70,000 of the loan, then the extra interest margin and any low equity fees can be avoided and Banks will be more likely to make a contribution to legal fees. That can bring significant savings.
Parents acting as guarantors can save their kids a bucket load of cash but they need to be careful about what sort of guarantee they are signing up to. Some lenders offer a guarantee limited to the facility and then only to that part of the facility above 80 percent. This means that parents won’t be liable for any other debts and their obligation will be automatically dropped once the facility is paid off. Other lenders may seek an all obligations guarantee which means the parents guarantee all their offspring’s borrowings taken out. This can include credit card borrowings.
Risks associated with all obligation guarantees scare most lawyers into strongly advising their clients not to provide guarantees to their kids to help them buy a home. But limiting guarantees and having a rapid repayment plan make them more acceptable, as can insisting on mortgage protection insurance to cover for sickness, injury or redundancy.
One strategy that can be used is to have two loans to buy a house. One loan can cover the smaller guaranteed portion of the sum borrowed, in the case of the above example of $70,000. This can be set to be repaid over five years, automatically ending the guarantee once it is gone. The other portion can be an interest only loan which switches to principal and interest repayments after five years, once the guaranteed loan is paid off. That scenario not only saves on repayments but there is less principal owing after five years. There are also opportunities for guarantees to be removed in the case of the value of a home having risen, reducing the LVR of the loan.
In many cases the parental guarantee requires security be taken by the lender over one of the parent’s assets. This can be a house but doesn’t have to be. A term deposit can also be used.
The rise in guarantees is being noted in Parliament. The recent Commerce Committee report into the Credit Contract and Financial Services Law Reform Bill says loan guarantees should be covered by the planned responsible lending code. This would mean lenders could not lend with impunity to people unlikely to be able to afford repayments just because there is a guarantor like a parent willing to underwrite the loan. But that’s not a game Banks play at. Most of the ugly stories about guarantees are with the likes of finance companies. Banks are generally pretty responsible about these things.