Home ownership is arguably the most expensive purchase for the average person. Coincidentally, it also presents the single-largest debt obligation.
Obtaining a mortgage is difficult. Borrowers need to demonstrate they have a solid credit history and financial position. More importantly, they must establish they can manage a loan that spans multiple decades. They may still not obtain a mortgage despite satisfying these requirements.
One factor that tips the scale in the borrower’s favour is a guarantee. The following post defines a guarantee and why it may be a deciding factor to home ownership. As a reminder, the information contained in this post does not represent independent financial or legal advice.
What exactly is a guarantee?
To answer this question, let’s first reintroduce the concept of a mortgage. Put simply, a mortgage is a long-term financial obligation. However, a mortgage is secured by the home, which is unlike a traditional loan.
A typical mortgage involves two party types – a lender and a borrower. However, some mortgages involve a third party, also known as a guarantor. This party provides an assurance (or ‘guarantee’) that, should the borrower default on the mortgage, the guarantor will assume the borrower’s obligations.
It’s worthwhile noting that a guarantor differs from a co-signer. The latter party shares in the mortgage obligation with the other borrower. A co-signer is also responsible for all terms and covenants outlined in the mortgage instrument. However, a guarantor enters into a separate arrangement which secures the underlying mortgage.
Who Benefits From a Guarantee?
Firstly, the lender is a big winner from a guarantee-secured mortgage. In the event the borrower defaults, the lender has a claim to the home. The guarantee only serves as an additional layer of protection for the lender.
The borrower also benefits from a guarantee. In some instances, borrowers may not be able to obtain a mortgage without a guarantee. Alternatively, even if they are able to obtain a mortgage without a guarantee, they may be subject to an above-average interest rate. This is because the lender may have reservations on the borrower’s ability to repay the loan, and therefore prices this uncertainty into the interest rate. However, a guarantee mitigates the lender’s exposure and consequently reduces the borrowing costs.
Lender’s mortgage insurance (LMI) is not needed where the mortgage is backed by a guarantee. This further reduces the financial burden imposed on borrowers.
What are the risks associated with a guarantee?
It is important to remember that a guarantee is a serious financial responsibility. Put simply, the guarantor satisfies the mortgage on the borrower’s behalf, should that borrower be unable to satisfy the obligations.
Most guarantors have a familial relationship to the borrower, usually in the form of a parent or close relative. However, while their intentions may be pure, they must have full appreciation of the consequences of being a guarantor, prior to them entering into such an arrangement.
A significant consequence is that a guarantor may forfeit his/her own assets if they cannot satisfy the guarantee obligations. Furthermore, a guarantee may negatively impact the guarantor’s creditworthiness, along its overall borrowing capacity.
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Entering into a guarantee can serve as the lifeline for someone close to you to recognise their home ownership dream. However, you must balance your willingness to support others with the potential economic cost of having to assume their place.
The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.