Why would someone do that? my 10-year-old son puzzled this week as I explained the concept of going guarantor.
Going guarantor is agreeing to guarantee someone else's loan with the bank. The answer to his question was "because they can" and "it's noble to help others". The trouble is that it's risky.
Yet it happens every day of the week. A trusted member of the family needs to buy a house, raise money for a business, or even buy a car. By simply signing a piece of paper and guaranteeing the loan you can make it happen for them.
It's not just a formality. Sometimes the person whose loan is guaranteed can't make the payments. Redundancy, disability, divorce, business failure, interest rate rises and a host of other problems can arise and the guarantee comes back to bite whoever signed it.
Mortgage broker Jeff Royle of iLender had a client recently who had trouble getting a mortgage, thanks to a guarantee given to a cousin. The cousin had defaulted on the loan leaving a black mark on the client's credit file.
Trade Me member mothergoose-nz posted on the community forums that she was forced to pay her daughter's mortgage after she lost her job following the Christchurch earthquake.
When the bank has a guarantee it can call in the debt from either the person who has got into financial trouble or the guarantor. It will go after the easiest money, and if that's your home you are unlikely to have a leg to stand on.
The guarantees that offer the biggest problem are often those that have been forgotten about. In one case heard by the Banking Ombudsman, a Mr Q had agreed personally to guarantee a loan taken out by a company of which he was a director. He later resigned and assumed that he no longer had any responsibility under the guarantee.
But when the company subsequently got into financial difficulties and was unable to repay the loan, the bank sought to recoup its money from Mr Q.
Anyone going guarantor should seek independent legal advice. They often don't, however, or don't really understand the advice.
Lawyer Dennis Gates says being asked to be a guarantor is a bit like being asked to test a guillotine. "So long as the blade doesn't move then everything is fine. Once it starts its downward journey you are in trouble."
Most people who sign guarantees have little real idea of how far-reaching they can be. Unlimited guarantees cover future borrowing, not just the loan in question.
Often, says Gates, there is no requirement for ongoing disclosure by the bank so you may not even know you're at risk.
Case number 29396 heard by the Banking Ombudsman should ring warning bells. In that case, Mr A and a group of friends formed a company to buy investment properties and signed an unlimited deed of guarantee.
Unknown to the others, two of the shareholders, Mr and Mrs C, took out another loan with the bank to buy a rental property. When the couple got into financial difficulty with repayments the bank told the other shareholders they would need to repay the debt if Mr and Mrs C couldn't.
It's a real dilemma for parents who want to help their children into a house or business. On one hand, they don't want the kids paying rent and saving until they're 40 for a house deposit. On the other hand, if those children haven't saved at all are they a good risk to go guarantor on?
The risks of going guarantor can be lessened in a number of ways. Banking Ombudsman Deborah Battell recommends that anyone considering going guarantor asks themselves:
• Do you know if the person asking you to guarantee their loan has the ability to service and repay the loan?
• Do you know what their credit history like?
• Do you know if the borrower already has other obligations to the banking service provider? Do you know the extent of their obligations?
• Is the borrower likely to let you know if they start to find it difficult to keep up with their obligations?
• Are they likely to keep you informed if their obligations increase?
• Could you afford to meet all of the borrower's obligations?
• Can you assist the borrower in another way?
If the bank will agree, the guarantor should limit the amount of the guarantee. If, for example, that's $50,000 for Charlotte or Jake's first mortgage, then agree to guarantee the $50,000 for a set period. The house will need to be revalued at the end of that time and new documentation completed at the end, which will cost money.
Beware, however, says Royle, that although you can ask the bank to discharge a guarantee after a certain period, the bank has to give consent. It may not if the loan-to-value ratio hasn't dropped sufficiently, there has been a problem with payment history, the borrower still doesn't earn sufficient income to service a mortgage or there is a black mark on the borrower's credit file.
What's more, the guarantee is still enforceable for two years. "This is to stop people giving a guarantee one day and cancelling it the next," says Gates.
McIntosh adds that you can "cancel" a guarantee unilaterally in writing, but only in relation to future borrowings. "It just doesn't affect your liability for money already borrowed and interest and costs on that amount," he says. "So unless the bank agrees otherwise you're stuck with the guarantee on the borrowings under the mortgage, whether you like it or not." At least you're off the hook for future borrowing.
Increasingly, parents (and grandparents) are becoming co-owners of their offspring's property rather than giving guarantees, says Royle. They are still at risk, but have a little more control. The child can still withdraw their KiwiSaver savings, provided the parent and child together don't earn more than $100,000 a year.
McIntosh had some good advice for anyone considering going guarantor. If possible, extend your own mortgage and then lend the money to the child rather than going guarantor on their entire mortgage.
He also recommended not having deposits with the same bank as the child if you are the guarantor. "The bank is likely to raid them if things go wrong, whereas you want them to at least try to recover from the child first."
Some of Royle's clients have gifted the money and then taken out a caveat on the property title. Beware, however, that there is a big difference between gifting and lending money. Should the couple split, the parent can call in the loan. If it was a gift, the other party takes half.
Children and business partners come in all sorts of flavours. Some feel entitled to a guarantee. Others would do anything to avoid putting anyone else at financial risk.
One who posted on Trade Me's community forums riled many. Poster fostey1 said his parents were borrowing money to give him a home deposit as well as going guarantor - despite that he had got into bad debt in his 20s. "My parents ... are giving me my inheritance money early," he said.
"Your parents must have rocks in their head," replied another Trade Me member. Another posted: "There is no mention of your own savings. I take issue [with] the total disregard for what will happen as your parents age. What if they need rest home care ($1000 a week each), or need their money for their health, or God forbid, want to spend their own money on themselves, taking a trip around the world? It is all about you, you, you really." Let's hope those parents never need to pay for the guarantee.
Like many people involved in the guarantor circle, fostey1 didn't really understand the risks. He said "they won't loose (sic) their home as its (sic) in their trust" - not realising that the bank wasn't going to be seeking a guarantee from asset-free people. It would have ensured that there were assets to grab if the guarantee was needed.
On the other hand, another poster whose parents and in-laws had both offered to go guarantor was a little less entitled: "Both sets of parents have offered. It's a great deal of trust they have bestowed in us. Not sure I am ready to put that commitment on to them."
Not going guarantor protects the relationship between parent and child or business partners.