According to the Australian Bureau of Statistics, first homeowner activity has increased by 51% since March 2016. First home buyers now account for just short of 20% of all new home loans.
Whilst housing affordability has improved slightly recently, it is still tough for first home buyers to get onto the property ladder. However, the current low interest rate environment and the recent dip in prices is clearly encouraging more first home buyers.
So, what is the best way to help your kids get into the property market? And is there anything you need to do now?
Challenge has and will always be saving a sufficient deposit
There are two factors that will determine whether a person is ready to purchase their first property:
(1) Cash flow
Do they have a stable and reliable amount of surplus cash flow that they can contribute towards repaying a loan? There are usually two main considerations. Firstly, how stable and consistent their income is expected to be in the short to medium term? This normally requires permanent full-time employment or an established self-employed business. Secondly, do they have good cash flow management and consistently spend less than they earn i.e. are they good savers?
Do they have enough deposit to contribute towards the acquisition? Most banks will lend up to 95% of a property’s value. Therefore, first home buyers need to contribute:
- a 5% deposit;
- pay for the mortgage insurance premium. This is an expense that is charged by the bank if you borrow more than 80-85% of a property’s value. The cost of mortgage insurance is typically in the range of 3% and 4% of the loan amount (at a 95% LVR). A few lenders permit borrowers to add a portion (up to 2%) of the mortgage insurance premium onto the loan. The rest must be paid from cash savings; and
- any acquisition costs which could include stamp duty (which may be nil depending on the first home buyer incentive), buyers’ agent fees if you choose to use one and legal fees.
Therefore, typically, first time buyers need to accumulate a sizeable deposit, and this can unfortunately take many years to save (over which time property prices will probably continue to climb).
Having enough deposit is often the primary hurdle to overcome for first time property buyers.
Best way to help is to help yourself first
Often my clients request that their financial plan include the goal that they would like to help their kids buy a property. Sometimes clients think that buying one property per child (for example) now is a good idea. There are a few flaws with this approach, including:
- The best way to help your children is to help yourself first. Build your own asset base. If you have a very strong asset base in the future, you will have the latitude to help your children in lots of ways. However, if you don’t have a strong asset base, you risk being in a situation where you are relying on your kids for help, not the other way around.
- Buying assets now, ultimately for your children’s use, has many challenges. Firstly, if you eventually gift or sell the property to your child you will have to pay stamp duty and capital gains tax. Secondly, how do you know what property type and location will best suit your children in the future?
- You may want to help your children in different ways and at different times. Some young adults can be very astute with money from a very young age. However, others can take many years to learn basic cash flow management. Forcing a person into property ownership before they are ready won’t produce positive outcomes.
Start with teaching good cash flow management
We all know that kids learn a lot (often subconsciously) from their parents through observation and experience. Therefore, it’s good to openly discuss the principals of money management, without having to disclose personal details. Discussing topics such as how to budget, focusing on getting value for money, that most financial goals typically take some sacrifice to achieve, not everything is “easy” or “simple”, that patience and delayed gratification are critical and so on, is a good idea.
I don’t mean for this tip to sound too preachy. The point I am trying to make is that you can teach a lot of these important lessons many years before your child is ready to buy their first home.
How do you know when your child is ready to buy a home?
A core tenet of astute financial management is to never borrow more than you can afford to repay. And teaching a person to compromise this tenet is not a good idea in my opinion. Therefore, it stands to reason that your child must be in a good cash flow position before contemplating a property acquisition. As discussed above, they must have a stable income and proven ability to save money regularly. Once they reach this position and if they show a genuine interest in property, then they are probably ready.
Best way you can help is to provide a family guarantee – here’s how it works
A family guarantee is a way of providing the bank with additional security for your child’s loan. This has two benefits. Firstly, they don’t need to save as much deposit (as referred to above). This means that once they have a satisfactory cash flow position, they can get into the property market without further delay. Secondly, reducing the child’s loan to value ratio to 80% or lower means they no longer must pay for mortgage insurance, saving a significant amount of money (approximately 3% to 4% of the loan amount).
A family guarantee is provided by using equity in your property (either home or investment). It is usually limited to a dollar value. For example, let’s assume your child want to buy a property for $600,000 and they only have $10,000 in savings. For the sake of this example, we will ignore any costs (legal fees, stamp duty, etc.). We could structure a family guarantee loan as follows. We would apply for a loan for $590,000, or in fact probably $600,000 so the child could retain their savings as a buffer. This loan would be secured by the new property ($600,000) and a limited guarantee of $150,000 provided by you. Therefore, the bank holds security worth $750,000 for a loan of $600,000 which is a loan to value ratio of 80%.
Then, in time, when the child’s property increases in value and its worth more than $750,000, we would approach the bank and request they release the guarantee (if they decline this request we could simply refinance to a new lender).
This arrangement has the following pros and cons:
- It doesn’t cost you anything except some legal fees (the bank will want guarantors to obtain independent legal advice). That is, you do not have to dip into your own nest egg to help your children.
- It still puts the onus of responsibility on your child to qualify for the loan using their income only.
- The property will be in your child’s name only therefore avoiding any need to change the ownership in the future.
- These arrangements are typically short-term. In my 17 years of experience, no family guarantee arrangement has remained in place for longer than 5 years. However, there are no guarantees (excuse the pun!). If the property’s value remains stagnant and the loan balance doesn’t reduce, the arrangement could be in place for the whole term of the loan.
- You can still downsize or upsize. Sometimes parents are worried about providing a guarantee if they plan to downsize their home in the future. Providing a family guarantee shouldn’t prevent you from doing this but please do get personalised credit advice to confirm this is correct for your situation.
- If your property already secures an existing mortgage, you and your child will need to use the same lender. This means you will either need to refinance or they will need to use your lender. Seek advice from a mortgage broker (i.e. us) in relation to which option is best.
- Providing a guarantee will eat into your equity. Therefore, you will need to take this into account if you have plans to increase your borrowings in the future.
- Whilst the guarantee is limited in dollar terms, practically, a lender can’t sell just a portion of your property. If your child defaults on their loan and the bank sells their property for less than what they own them, the bank will want you to pay for the shortfall. If you cannot do so from your own funds, the bank will sell your property. Whilst the guarantee amount is limited and you will keep the remaining sale funds, it doesn’t change the fact that the property will be sold which could have wider reaching consequences (e.g. CGT).
The above list is generic and may not include all pros and cons. Therefore, you must obtain independent financial and legal advice.
Make sure they buy well
One other way to help your child is to counsel them to “buy well”. By this I mean buy an investment-grade asset – or as close to an investment-grade asset as possible. The first property someone buys is arguably the most important. Because if they do it well and enjoy some capital growth, it creates a lot of financial opportunities in the future.
Of course, I realise that young adults don’t always listen to their parents, so there’s only so much you can do. If you start this conversation at a young age, perhaps you can indoctrinate them with a sound financial education.
Build your own wealth and educate your children
Perhaps the best summary of this blog is that all you need to do is take steps to build your own wealth to strengthen your financial position. This must be your primary aim. And educate your children as much as possible about money and property. When the time comes, the best way to help them is via a family guarantee.