The Traps for First Home Buyers Borrowing from their Parents

The corona virus crisis has had a devastating impact on many livelihoods, resulting in thousands of job losses, record unemployment, and great uncertainty for would-be first home buyers in terms of their ability to obtain and service a home loan.

The crisis has also severely impacted property sellers who have had to endure a period of months during which social distancing rules restricted the ability to hold in-person open house inspections and conduct sales auctions, with the result that many sellers have been forced to postpone the sale of their property. On the other hand, those sellers who were not subject to time pressures have simply withheld their property from the market to avoid the prospect of it languishing there for months without enquiries from interested buyers – or worse, being perceived as a desperate seller and only attracting “low-ball” offers.

On the flipside of all this doom and gloom, the pandemic has also coincided with the lowest home loan interest rates in living memory, which have been predicted to remain with us for the next few years. That fact, coupled with new incentives being proposed by the government to assist first home buyers in particular, has encouraged many people who may not have sufficient resources of their own to be able to obtain a loan from a bank to look to the “bank of mum and dad” for assistance, especially in terms of helping out with getting the essential deposit for the purchase. In some cases the solution has been for the purchaser’s parents to even become a part owner in the new property.

Whilst these strategies may have enabled many first home buyers to get into the property market and perhaps take advantage of both record low interest rates as well as the odd real estate bargain where a seller was indeed forced to sell at less than fair market value, there are some traps for first home buyers (and their parents) in these arrangements that need to be considered carefully to avoid future discord, such as:

Making a gift or a loan?

Often the home buyer has the ability to service a loan, but can’t scrape together enough funds for the initial deposit. In these circumstances often their parents are called upon to assist with a cash contribution.

In many cases the bank will want to see this parental contribution styled as a gift, so that the bank does not need to be concerned about taking into account the impact on borrowing capacity of this additional loan commitment (and also to ensure that the bank maintains first preference in terms of any security obtained for their lending).

However, if the amount is significant, irrespective of how the contribution is treated as far as the bank is concerned, it would be much preferable for the parents if the contribution was treated as a loan as between themselves and their child for the following reasons:

• As a loan, it means that it can if necessary be paid back to the parents. Whilst the parents may believe that they do not need the loan to be repaid, as they get older they may find that their health is deteriorating and they need to access funds to pay for emergency surgery or other ongoing increased medical needs such as going into aged care or hiring a nurse for at home care. Whilst it is important to help out your family members when you can, you cannot ignore the possibility that unforeseen health and medical circumstances may mean that you need the return of the funds more than your child needs them.
• whether or not the loan is ultimately repaid, it is also a clear reminder of how much the parent has provided in support to their child, and can be taken into account in the parent’s estate planning after they die - and if it is never repaid at least it can be netted off against that child’s share of their parent’s estate.
• Often the loan is made on the basis of being interest free and repayable on demand. However, whilst the issue of payment of interest is entirely up to the parent, by making the loan repayable on demand the 6 year period under the relevant statute of limitations begins to run from the date of the loan, so that unless the loan is in some way acknowledged by the borrower during that period it will become unenforceable after that period expires. A better approach would be to specify a number of years as the loan term, which may be subject to early repayment and any specified events of default (like a bank loan) that may trigger earlier repayment.

Lending to a couple

Often the borrower child is in a legal or de facto relationship with another person. If so, another reason why it may be desirable for the loan to be repayable is that in the event that the relationship breaks down, the parent would wish to exclude the amount of the loan from any settlement between the child and their former partner. If so, the following points should be observed:

• The loan should be secured against the home, ideally by a registered mortgage;
• If the property is to be purchased in both names of the couple, then the loan should also be made to the couple to ensure that the child’s partner is also primarily responsible for repayment (including on the untimely death of the child) – if the child’s partner resists, it needs to be pointed out that this is a condition of the loan being made at all in the first place;
• The loan should be made on ordinary commercial terms (like a bank loan), although it is up to the parent whether they wish to require the payment of interest. However, if interest is specified to be repayable only upon repayment of the loan, and one of the events that may trigger early repayment is a relationship breakdown, it may enable some portion of any increase in the value of the home itself to be recovered by way of the payment of interest.

Consequences of parental co-ownership

In some cases it may be decided that the parent should become a co-owner with the child, where the proportion of ownership by the parents correlates with the proportion that their financial contribution represents of the total purchase price.

This strategy has the advantage that the loan amount is automatically secured by reason of the co-ownership of the property by the parent. However, some consequences need to be borne in mind:

• Capital gains tax may be payable by the parent on any capital gain made in relation to the sale of their share of the property, unless they also live in the property as their own principal place of residence;
• Land tax may be payable by the parent in respect their share of the property, unless they also live in the property as their own principal place of residence;
• If the parent dies, their share of the property becomes part of their deceased estate, and may be subject to the terms of their Will. In this situation it would be important for the parent to make a specific provision regarding their co-ownership share of the property in their Will, such as leaving their interest in the property to their child (or to the child and their partner, as the case may be).

Going guarantor

Another popular method of a parent providing financial assistance for a child buying their first home is to agree to be a guarantor for the loan. The main advantage of this approach is that it does not require any upfront cash payment by the parent. However, it is absolutely fraught with danger for the parent, particularly if the parent has to provide security for their guarantee (such as by a registered mortgage over their own separate real estate). In these cases it is not unheard of for the failure of the child to make their loan repayments to result in the loss of not only their own home but also that of their parents!

If agreeing to be a guarantor for their child is the only option that will enable the child to obtain a bank loan, then at the very least it should be agreed with the bank to limit the amount of exposure of the parent under the guarantee – for instance, if the reason for requiring the guarantee is that the child could not come up with a 10% deposit, then the amount secured by the guarantee should be limited to the dollar amount representing that deposit.

Conclusion

The “bank of mum and dad” is these days an important resource for many first home buyers to get their foot in the door of the property market. Whilst that can be a sensible strategy in these trying times, the traps for the unwary must be borne in mind and guarded against wherever possible.