Kids turn to the Bank of Mum and Dad for all manner of reasons, but one of the most monumental is for help when it comes to buying their first home, leading an increasing number of generous parents and grandparents in Australia to sign up as guarantors on their adult children’s or grandchildren’s mortgage.
But following stark predictions from economists this week that property prices across the country could drop by as much as 20 per cent over the coming year, those parents and grandparents could find themselves at risk financially if they’ve agreed to be liable for the repayments on someone else’s mortgage.
Mortgage guarantor products allow parents to help their adult children to get a foot onto the property ladder without the parent having to produce a cash lump sum, by effectively promising the lender that if the buyer (their child or children) is unable to meet their mortgage repayments, they will cover the costs.
In becoming a guarantor, the parent puts up a portion of the equity in their own home as security on the child’s loan, which is then used by the bank, along with the lump sum the young buyer has saved, as a deposit on the property. Guarantor products usually require the parent to be ‘on the hook’ for the loan until the child builds the equity in the home that’s equivalent to 20 per cent of the property’s value. At that point, the guarantor is released from their obligations.
Starts at 60 spoke to Graham Cooke, insights manager at finder.com.au, about the risks posted by falling property prices to both first-time buyers who rely on guarantors, and to family members who agree to become guarantors.
If the child has put in only a small cash deposit themselves, and house prices fall substantially, they have a far narrower buffer than other home owners against being in negative equity. Being in negative equity means the market value of a property is worth less than the outstanding mortgage attached to it, which can happen if there’s little actual equity in the property, such as in the case of a small cash deposit or only a short period of mortgage repayments.
That causes a problem for the mortgagee should they need to sell the property, because the amount it would fetch at sale would be lower than the amount remaining to repay on the mortgage – leaving them effectively “locked in to the property”, Cooke explained.
The problem becomes worse if the sale looks like being forced one because, for example, the mortgagee anticipates being unable to continue to meet repayments or must move from the home. A guarantor may have to step in in this case, and cover the mortgage repayments until the house is out of negative equity and thus more saleable.
“It’s not going to be a very positive situation to sell a house and still owe money to the bank, and you’re not going to be able to refinance that loan very easily,” Cooke said.
In the most extreme case, if the home did have to be sold, and fetched less than the value of the mortgage, and the mortgagee was unable to make up the difference, the guarantor themselves could be held responsible for covering the outstanding amount owed to the lender, up to the value of their guarantee – even if it requires selling the guarantor’s own home to cover the debt.
Theoretically, merely requiring a mortgage guarantor in the first place put a first-time buyers at greater risk of negative equity, Cooke noted, because their small deposit meant that it only required a relatively small drop in house prices to wipe out the equity the buyer had in the property.
“Those people are going to be hit quicker when prices drop,” he added. “If you only pay 10 per cent, you’ll already be nearing 10 per cent drops in some cities, so you’d already be close to negative equity if you were on that type of loan. This potential drop of 20 per cent in prices means that we could see prices drop so much that it wipes out all of the equity in the deposits that first-time buyers are putting on their houses.”
Cooke advised parents and grandparents who may be considering acting as guarantors to consider loaning their children a lump sum instead, which they can put towards the deposit, meaning the young buyer would own a larger proportion of the property to begin with.
He also stressed the importance of exercising caution, particularly in light of Finder’s recent RBA survey that predicted house prices across Australia, particularly in Melbourne and Sydney, could be set to fall by as much as 20 per cent within the next 12 months, adding: “You need to be very cautious about the deposit you’re placing on a house in a declining market”.
“If you, your children or grandchildren are buying, make sure they can afford to pay back 3 per cent more than the interest rates they’re currently being quoted for on their mortgage, because we think that when interest rates move next, they are going to go up,” he added.
Aside from the impact of falling house prices, mortgage guarantor products pose other potential risks to the guarantor. The existence of a security, or lien, over the parent’s property means they cannot easily sell their home should they require, and the parent’s own borrowing capacity may be reduced by the existence of the security.
However, they do offer benefits to the buyer, mainly because they allow them to avoid the additional cost of lenders mortgage insurance (LMI). The premiums for LMI are an extra charge applied to the mortgage of any borrower that doesn’t meet the bank’s minimum deposit threshold, which is usually 20 per cent of the property purchase price, and can add thousands of dollars to the cost of taking out a mortgage.