The Bank of Mum and Dad -Dangerous Game or Smart Strategy.

This week, we’re going to explore the workings of the expression, “The Bank of Mum and Dad” to understand what it means, the potential positive advantages and red flag potential dangers in going down this path.

First, what do we mean by The Bank of Mum and Dad.
The term relates to the use of financial assistance from parents to help their children to facilitate a large financial purchase, in this case Real Estate property.

This type of financial assistance generally comes in three different forms:
1. Non-repayable Financial Gift: gifting
2. Repayable Financial Parent Loan: private loan
3. Asset Backed Financial Guarantee: The guarantee to underwrite a childs financial position to enable them to enter into a mortgage with a Bank or Financial Institution.

All three forms of assistance are very generous examples of a heartfelt desire to assist children in the purchase of their own home. All three require great care in how they are structured and most importantly the type of asset purchased to ensure the funds are directed to a quality property. (We discuss this further in part two of this article).

Banks have contracts and so should you.
Unless you have unlimited wealth, all financial loans or gifts should come with a basic contract, a simple signed document that you’ve gifted or lent funds can provide protection in case of a relationship break down or other events. If you feel embarrassed or uncomfortable doing this, please just keep in mind that the unforeseen can occur in life and without any form of parameters or agreement the funds could be lost. A licensed solicitor can assist you in putting together a simple contract document.

Understanding the obligations of being a financial guarantor.
Of the three options listed above, option 3, Asset-Backed Financial Guarantee is the most common path taken by parents wanting to financially assist their children in a home purchase. The purpose of the guarantee is to take the place of the 20% deposit required in a standard 20/80 mortgage application, the 20% deposit would otherwise come from savings made by the child seeking the loan.

A Guarantor agreement involves a parent using a financial asset as collateral security, in this case to assist a child to qualify for a 20% Deposit/80% Loan to value ratio property mortgage. The asset used is usually the parent’s primary home (but can alternately be cash) and the amount contributed to the childs purchase can be up to 20% of the parent’s property value. The child making the purchase will need to finance the stamp duty and associated purchase cost and have the earning capacity to meet the serviceability of the total purchase loan, being 100% of the property purchase price.

Breaking this down - 20% of the purchase price covered by an asset backed guarantee from the parent, taking the place of a savings backed deposit, child covers the stamp duty and other purchase expenses, the Bank provides a standard 80% LVR Home Mortgage, the total drawings to be repaid via the mortgage are 100% of the home purchase price (plus interest).

The parent does not need to make any material payment toward the purchase although a contract does need to be entered into with the bank which will make the parent financially liable for the repayment of the guaranteed amount, should the child find themselves unable to service the loan resulting in the asset being sold by force or by choice and potentially below the 100% initial purchase value.

The Advantages of using a parental guarantee
1. No Mortgage Insurance required – Using a guarantor to cover the 20% deposit requirement via an asset-backed guarantee enables the purchaser to seek a regular 20% deposit/80% mortgage loan and completely avoiding expensive mortgage insurance required on loans under the 20% deposit threshold.

2. Enter the market sooner – The child purchasing the home can do so in a much shorter timeframe as the level of savings and the time taken to build savings have been substantially reduced, and the funds saved can be redirected toward stamp duty, property improvement, moving expenses etc.

3. Opportunity to release the Guarantor - Over the course of time as the property appreciates in value, the child can look to refinance the appreciated value of the property or sell for profit and release the parent guarantee.

The Disadvantages of using a parental guarantee
1. Larger income required - The child will require a decent source of income as the serviceability of the mortgage will be based on 100% of the purchase price, which would have been lower if personal funds had been used for the 20% deposit. This point alone could reduce the total purchasing budget and limit asset selection. It may also result in a narrower selection of potential lenders.

2. Low to no equity - A potentially longer timeframe to achieve capital value improvement may be experienced due to market conditions or poor asset selection, limiting equity growth, and leaving both the guarantor and mortgage holder locked in a lengthy timeframe of crossed collateralisation.

3. Asset selection matters – some assets appreciate faster than others, the selection of the right type of property is even more important when you are using someone else’s equity to underpin your purchase – Buying well is an absolute essential when using funds from the Bank of Mum and Dad. Seek the services of professional Buyers Agents like MCS Buyers who understand the property market and the capital growth opportunities of different property segments.

The Risks
When providing a gift, family loan, or asset-backed guarantee, it’s important to remain aware this will always involve the risk of loss of funds or having to repay someone else’s debt. A legally binding agreement can help lower this risk in part but will never 100% remove your exposure as a parent in the Bank of Mum and Dad. As mentioned above, asset selection is absolutely paramount, selecting a home that offers the scope to appreciate above market and enable the guarantee to be removed in the shortest possible timeframe should be a core focus when using the Bank of Mum and Dad.

Develop a timeline with an Entry and Exit strategy before becoming a Mum and Dad Lender.
This brings us to the most important point in part one of examining The Bank of Mum and Dad. Put parameters on the loan conditions. The point of using the Bank of Mum and Dad is to assist your children in entering property ownership. The purpose of the Bank of Mum and Dad is a leg up, not a forever financial commitment. During the time the guarantee remains in place, your principal home will underpin the financial arrangement, and no physical funding is required. Should you wish to sell your family home then you will be required to move the collateral guarantee to personal funds or an alternate asset (for example a bank term deposit). This could impact your own personal financial reserve of liquid funds while you remain guarantor which may be intended for use toward your own future home purchase.

In part two of this article we’re going to look at ways of mitigating risk by focussing on asset selection and timelines. Don’t miss this article! It will broaden your understanding of the right and wrong property types and the safeguards you can put in place to avoid negative equity traps and elongated cross collaterisation timelines.

If you live in Sydney and are in the process of helping your children into their first home, please reach out to us at MCS Buyers, the Strategic Sydney Buyers Agency.

Important Note: The above article is not intended as financial advice and serves as an example of a strategy practiced by clients we work for in securing quality property in the Sydney Real Estate market. It is strongly advised that anyone looking to buy property should first seek professional financial advice from a licensed accountant, financial planner, and mortgage broker to review their individual financial circumstances and abilities.