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Thinking about borrowing from mum and dad? Read this first

Record low interest rates, high auction clearance rates and the launch of the Coalition's new First Home Loan Deposit Scheme have catapulted First Time Buyers (FTBs) back into the spotlight.

With rates as low as 2.68 per cent, and APRA's recent changes to serviceability assessments increasing Australians' borrowing power, many have speculated FTBs may no longer need help from the Bank of Mum and Dad (BOMD).

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However, with the median house price in Australia sitting at just over $770,000, home loan deposits are becoming increasingly unaffordable, and FTBs are still looking to their parents for financial support.

Rates on the decline, yet deposits still out of reach for FTBs

With variable home loan rates on a noticeable decline, it may seem logical to assume FTBs are better positioned to afford the home of their dreams.

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However, low variable rates are only one part of the equation, as borrowers need to consider how much they can afford to borrow, known as serviceability, and how much they can contribute towards the deposit.

Lenders typically expect you to save a deposit amount between five and 20 per cent of the property value. If you cannot save a deposit of 20 per cent, you will need to pay Lender's Mortgage Insurance (LMI) to secure the loan.

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What is LMI and how does it work?

LMI is a one-off insurance premium that protects the lender from the potential loss that could occur if you default on your repayments.

If you do not have the cash to cover your LMI, you can add this onto your principal loan amount, known as capitalising the LMI. However, this could end up costing you thousands in interest over the length of your loan, and may impact your borrowing capacity.

Say, for example, you are approved to borrow $500,000. You have not saved a 20 per cent deposit and are charged $8,000 for LMI. If you capitalise the LMI, this $8,000 will be added onto the loan amount, but you will still only be approved to borrow $500,000.

This means you are now only able to put $492,000 towards the property value, and will have a shortfall of $8,000, unless you can cover this in cash, or with funds from the BOMD.

How likely is it that Aussies can save a 20 per cent deposit?

Taking the median house price of $773,635 as an example, it's clear that a 20 per cent deposit is out of reach for many Australians.

For a property that costs $773,635, you would need to save a deposit of $154,727 to avoid LMI.

Even a 15 per cent deposit to reduce the cost of LMI would require savings of $116,045.25.

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ABS data shows that on average, Australians earn an income of $88,492 per year. With loan deposit sizes now in the hundreds of thousands of dollars, avoiding or reducing LMI by saving diligently can begin to look unreasonable.

Enter the Bank of Mum and Dad (BOMD).

BOMD is the ninth biggest lender, with an average loan size of $78k

Data ran exclusively for Business Insider from Digital Finance Analytics (DFA) shows parents are still a major factor in determining whether their children can minimise the cost of LMI.

Analysis from DFA, gained from their rolling 52,000 household omnibus surveys to the end of October 2019, shows BOMD loan an average of $78,973.

In fact, the BOMD is now Australia's 9th biggest lender, with an estimated loan stock of $31 billion (allowing for new loans and run-offs) as of September 2019, according to the DFA survey.

This places the pockets of Australian parents ahead of BOQ, HSBC, AMP and Citigroup.

"Around 30% of first time buyers, mostly owner-occupied purchases, are getting help from the Bank of Mum and Dad," said DFA Principal Martin North.

"Just last quarter we estimate that 8,300 owner occupier loans and 1,500 investor loans required financial support from their parents."

Whilst the BOMD average loan of $78,973 is still $10,000 below the peak reached in 2017 (and varies by state and location) the survey reflects that parents are still a large factor in helping their children reduce or avoid thousands of dollars in LMI.

The risks associated with BOMD lending

According to DFA data, 42.9 per cent of those surveyed who received or provided a loan from the BOMD were "unsure" of whether the funds were a gift or a loan.

15.3 per cent had a formal loan agreement in place, 11.5 per cent had a verbal, informal loan agreement in place, 8.6 per cent were provided the loan as an 'early inheritance' and 21.7 per cent were sure the funds were a gift.

When it comes to BOMD lending however, there are risks that need to be assessed for both the child and the parents. North is concerned that FTBs who receive funds as a gift may have a diminished level of accountability, which could result in future defaults.

"We know that those who get help from parents are twice as likely to default in the subsequent five years compared with those who saved," North said.

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Guarantor Loans in Australia

In some cases, parents forego equity in their own property to support their child's purchase, in the form of a guarantor loan. However, it is difficult to assess the current number of guarantor loans in Australia, because there is no current dataset that exists to monitor these figures, and it is not a question included in the DFA omnibus survey.

Regardless of the lack of data, guarantor loans can be risky business. When you act as guarantor on a direct family member's home loan, you take legal responsibility for paying back the amount you’ve covered. If your child cannot or will not make the monthly repayments, fees and charges, the equity in your property is at risk.

For instance, you could act as guarantor on your child's loan to cover 20 per cent of the property value. If your child cannot meet their repayments, the bank can decide to sell the property to recoup their losses, regardless of whether the market is in good stead. If the bank cannot recoup 100 per cent of the loan value from the sale, you as guarantor are legally responsible for making up the difference.

Consider the following hypothetical: your child gets a $500,000 loan, and you act as guarantor for the 20 per cent deposit. If the bank can only get back 84 per cent of the loan value after the sale, you are liable for the remaining 16 per cent. This would be a whopping $80,000 that you as guarantor would need to repay.

DFA survey data shows that 93.4 per cent of the BOMD respondents expect the value of their existing property to grow enough to cover the loan provided to
their children. However, with house prices still showing an annual decline, you need to ask yourself, does the risk outweigh the reward?

Given the complexity of guarantor loans, it's worth researching the individual lenders' terms and conditions before you become a guarantor, to understand exactly what would happen if your child can't meet their repayments.

Household debt metrics: overused or accurate?

Data from the Reserve Bank of Australia (RBA) reports that for every $100 of income, households have $191.10 worth of debt, which some may see as a worrying sign.

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However, Propertyology's Head of Research Simon Pressley remains optimistic in his analysis, suggesting that macro debt-to-income ratio is a grossly overused metric.

"There’s no point pretending that every property costs the same and every household earns the same income," Pressley said.

"In this country's 230-year existence, there's never been a property market that was driven down by excess household debt."

Regardless of whether this metric is overused or exaggerated, it can still be useful in demonstrating the importance of monitoring your household debt levels. Especially if you are considering lending tens of thousands of dollars to your children without a loan agreement in place.

Things to consider before tapping into the BOMD

Whether you're an FTB who needs support from the BOMD, or you are the BOMD, it's important to follow these three steps before the money is lent:

1. Speak to a broker: mortgage brokers can provide free advice and guidance, with insider knowledge as to how loan agreements work, and the risks associated with this type of lending.

2. Speak to a property lawyer: lawyers can advise appropriate documentation and safeguards for both the FTB and the BOMD, including interest, repayment conditions and security.

3. Get a loan agreement: creating a formal loan agreement can ensure that both the BOMD and the FTB are protected and will reduce the chance of any heartbreak if things go sour.

As the BOMD, you can end up forgiving the loan, or gifting it to your child later on, but when it comes to financial arrangements between family members, it's better to be safe than sorry.

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