One home equity-sharing company offered me $200,000–without any monthly payments.
“When you get something for nothing, you just haven’t been billed for it yet.
–Franklin P. Jones
Equity sharing is no cure-all, even if they were to give me $200,000. There are costs and drawbacks to financing any real estate transaction. In this post, we will discuss various ways you can tap home equity and some of the pros and cons of each method.
An unconventional equity-sharing arrangement may be worth considering along with more conventional alternatives.
A PREVIOUS POST ABOUT EQUITY SHARING
You may recall that we helped our kids buy a house in San Francisco, one of the most expensive housing markets in the world, by using equity sharing. See here.
The Bank of Mom and Dad put enough equity into the home to reduce the monthly payment and make it feasible for the kids to buy it. But the temporary use of all that money was not free to our kids. We parents shared in appreciation (increase in value) of the home, but ONLY after our kids sold it. While they occupied the house, they did not make a payment to us.
They later sold their home, and we were repaid at a small profit. They did fine too.
Now some lenders/finance agencies are starting to promote the use of the same idea, but for tapping home equity instead.
BUT FIRST, CONVENTIONAL HOME FINANCE OPTIONS
There are several standard options if you want to access equity from your house and have enough equity and income. Most involve making monthly payments. Here are the primary methods:
Home Equity Loan—also known as a second mortgage- allows homeowners to borrow some of their home’s value. Once the loan is completed, the borrowed amount is paid to the borrower immediately. Payments are due each month and paid back in monthly installments. In addition, the loan is secured by your home, and you must make payments on time—nonpayment can eventually result in home foreclosure.
Home Equity Line of Credit (HELOC)— think of this like a credit card, with your home as collateral to make sure you pay the line of credit back. When you repay your balance, the amount of available credit is replenished and ready to borrow all over again. The amount you borrow can’t exceed the credit limit your lender sets. At some point, the amount you owe (usually about ten years after the start of the loan) is converted into a fixed payment, often over the next 15-20 years.
Reverse Mortgage—this structure is used by those typically 62 and older who want to borrow against their home and help finance and support their retirement. The home title remains in their name. As with the equity participation arrangement I described earlier, there are no payments while the owner occupies their house. However, there is a loan. Interest and other charges keep getting added to the home balance each month, so the loan balance keeps rising. The loan gets repaid when the owner no longer occupies their property and the property is sold.
SAME PRINCIPLE, DIFFERENT STRUCTURE
Several firms have figured out that equity participation can also be used to get money to homeowners without monthly payments, similar to a reverse mortgage, but without involving a loan.
CONDITIONS TO AGREE TO WHEN YOU SHARE EQUITY WITH YOUR LENDER
In exchange for getting some of your home equity in cash, you usually must typically agree to the following:
- To occupy the home
- To make necessary repairs upfront, fully maintain the property while you occupy it, and pay the usual ongoing homeownership costs: taxes, insurance, etc.
- To repay the debt upon moving out or after having occupied the property for a 10–35-year period as required by the lender, whichever is first.
- To pay for all your application, title fees, etc. Some lenders allow this to be financed.
- To agree that the value is about 2.5% less than the appraised value, so the lender has an additional cushion for the risk they are taking.
So, how much can you borrow? Most of the time, no more than about 15-20 percent of the home’s value. So, for example, with a home worth about $400,000, you can borrow no more than $60-80,000.
WHAT DO YOU PAY AT YOUR HOME’S SALE?
The greater the percentage of your home’s value you borrow, the greater the percentage the lender gets of any appreciation in your home once it is sold. Terms will vary but expect that for a loan at 10 percent of a home’s value, the lender will get about 40 percent of the gain upon sale. If you borrow more than 10 percent, the percentage of appreciation gain that goes to the lender increases.
For an oversimplified example, say you borrow $40,000 against a home assessed at $400,000. Further, suppose you later sell the house for $500,000. The lender will be paid about $40,000 at the sale (40 percent of the $100,000 gain) plus the original loan amount.
IS THIS A GOOD IDEA?
Equity sharing is very difficult to analyze based on historical interest rates, home appreciation rates, and other hard-to-predict factors.
Here are some advantages of equity participation:
- There are no payments until the home sale
- Qualifying owners can use this option at any age (unlike a reverse mortgage)
- Upon sale, you will at least get the original appraised value of the house back, barring a complete collapse of housing prices.
- If you hold the property for more than a few years (usually five), you have the option to pay the lender back and remove them from the title.
Here are some disadvantages:
- A very low appraisal of your current home’s value can mean the lender gets a high payout upon sale.
- You cannot rent your house during the equity sharing period. You may be able to do that with a second mortgage or HELOC, but not with equity participation.
- You cannot gradually withdraw money like a HELOC. It must be taken all at once.
- You cannot borrow more than 15-20 percent of your home equity. By contrast, other options can sometimes allow a far more significant amount of equity to be borrowed.
- The lender does not share in potential losses.
EQUITY PARTICIPATION AND HISTORY
It is hard to say whether a conventional loan or equity sharing is better for potential borrowers.
Here is a thirty-year analysis that shows what has happened historically. Obviously, that is no guide to the future, but it provides a little context.
In 1990 a typical home in America sold for $122,900 on average. In 2020 the average priced home sold for $394,900. So, if a participation lender lent $12,200 in 1990, a sale in 2020 netted them 40 percent of the price increase–or $108,800, plus the return of the amount borrowed (40% of $394,900- $122,900). That is about a 900 percent lender’s return over 30 years. And that does not count the amount the lender gets by discounting the house’s appraised value at the beginning.
But be careful before you assume that the lender gets a disproportionate profit. For instance, rates in 1990 were almost 11%–more on a second mortgage, probably about an astronomical 13 percent. That is not a bargain for a borrower either. And the monthly payments were high.
Moreover, a complete analysis depends on what you do with the equity money when you get it. For example, suppose the owner had taken the $12,200 proceeds and invested in the S and P 500 stock index. She would have made a 2,107 percent return during the same period for a gain of $257,054.
So, analyzing equity participation is a mixed bag and a tough analysis. Whether you use this arrangement or not MUST be a discussion between you and your financial fiduciary.
EQUITY SHARING AVAILABILITY
The companies that offer these services are comparatively rare. By my count, there are only about a half dozen, and many operate in only a few states. Moreover, the conditions they impose on borrowers vary significantly by company.
So understand that I am not recommending this or any other option; it is just something that you should know about and discuss with your financial fiduciary to see if it meets your needs.
But the more you know your options, the more likely you will reach the best financial decisions for you and your family.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
Photo Credit: micheile dot com
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