Home Equity Agreements: How They Work
If you’re looking for ways to leverage your home equity, a home equity agreement may catch your eye — especially if you have low credit or a lot of existing debt. Strictly speaking, home equity arrangements aren’t loans, but they do allow you to access cash. In return, you agree to pay a lump sum later, calculated using your home’s value at that future date.
We’ll cover what you need to know about home equity arrangements before signing a contract, what to look for in a contract and how this option compares with more traditional ways of tapping your home equity.
- A home equity agreement provides cash now but obligates you to pay a lump sum later. The lump sum is usually due at the end of the contract term, or immediately if you sell or refinance.
- Home equity agreements are usually more expensive than traditional equity loan options. While a typical interest rate for a home equity loan or HELOC is around 6% to 9%, the effective annual rate on a home equity agreement can be more like 19% to 22% under many contracts.
- This type of financing may fit a homeowner who can’t qualify for traditional equity financing and has a good exit plan. But it’s generally a bad idea for someone expecting to stay in their home long-term who has no specific way to repay the settlement amount.
What is a home equity agreement?
A home equity agreement is a fairly new financial product that goes by many names, including home equity investment, home equity contract or shared equity agreement.
These products allow homeowners to receive funds today if they promise to “share” a portion of their home’s value later — with no monthly payment and no interest payments in between. However, when the large lump sum comes due, it will typically be larger than the interest you would have paid using a comparable home equity line of credit (HELOC), home equity loan or cash-out refinance to access cash.
The home equity agreement company places a lien on the home, so if you can’t pay the settlement amount at the end of the contract, they can force you to sell the home or take it through foreclosure.
Technically, a home equity agreement is an investment contract or equity sharing, not debt. That technicality lets companies say that they don’t charge interest or require payments. However, in practice, every aspect of a traditional equity loan has an analog in a home equity agreement.
| Home equity loan feature | Analogous feature in a home equity agreement |
|---|---|
| Debt (borrowed funds) | Obligation to pay a lump sum |
| Interest | How much you pay over and above the amount you received in the initial payout |
| Home serves as collateral | Lien placed on the home, which can force you to sell or enter foreclosure to pay the settlement amount |
How a home equity agreement works
As with a mortgage loan or home equity loan, you typically have to submit an application with your personal financial information and get a home appraisal. If you’re approved, you’ll receive your payout and can continue on as usual for the 10 to 15 years of the contract. During that time, you’re usually required to live in the home and continue to maintain it.
How repayment works:
Typically, the end of the contract triggers the final lump sum (also known as the “settlement payment”). However, selling or refinancing can also trigger the settlement payment to come due.
How “equity sharing” works
Every home equity agreement is an individual contract that calculates the amount you must pay the company using a unique formula. All of these formulas are based in part on your home’s value, which is where the “equity sharing” concept comes into play. You’re promising to “share” a portion of your home’s appreciation over the period of the contract.
How the contract works:
Every contract involves fine print that shapes how much you’ll have to pay. Always take the time to identify the key factors, which we list in the box below. Most contracts come with caps on how much you can pay total, typically 18% to 20%, though if your payout is triggered early, the effective rate can exceed that.
Here are some of the key features of a home equity contract:
- Calculation method. Whether the company’s share applies to your home’s total final value or only its change in value.
- Starting-value adjustment. Any “risk adjustment” or discount to the starting home value, which can create artificial appreciation.
- Share percentage. The portion of value or appreciation the company can claim.
- Cap: The maximum settlement amount or maximum annualized growth rate, if there is one.
- Final valuation process. How the home’s value is set at settlement, who selects the appraiser and how disputes work.
Fully understanding the exact formula in any contract you’re considering should be your number one priority, especially since many involve convoluted mechanisms that skew the contract in the company’s favor.
What a home equity agreement really costs
As we already touched on, how much you’ll pay to fulfill a home equity agreement can’t be known by anyone — even the company that designed the formula that calculates it — until the end of the contract. That’s because it depends on how much your home value went up or down during the period of the contract. If your home appreciates, you’ll pay more; if it depreciates, you’ll pay less.
The example below illustrates how the amount you must pay can change under different circumstances.
Home equity agreement example
Let’s say you own a home worth $500,000 and take a payout of $50,000 from a home equity agreement company. In return, you agree to pay the company 20% of the amount your home appreciates over the contract period. There’s also a 20% annual return cap over the 10 years of the contract.
| Appreciation scenario | How much you’ll pay | Comparable interest rate
This is an interest-rate equivalent, not a loan APR, since the agreement has no monthly payments.
|
|---|---|---|
| 8% annual appreciation | $215,892 | 15.75% |
| 6% annual appreciation | $179,085 | 13.61% |
| No appreciation | $100,000 | 7.18% |
| 30% price fall, followed by 3% appreciation | $94,074 | 6.52% |
As you can see, the amount you’ll pay can range widely depending on what happens to your home’s value over the time period covered by the contract.
Who qualifies for a home equity agreement?
There is no single set of qualification guidelines for home equity agreements, but most have fairly loose requirements compared to traditional equity-tapping mortgage options. In many cases, there is no minimum income nor maximum debt-to-income (DTI) ratio requirement.
The following captures typical practices, but all requirements vary by lender:
| Minimum credit score | 650 |
| Amount of home’s value accessed | 15% |
| Contract period | 10 to 30 years |
| Repayment | Lump sum |
| Typical interest rate equivalent | 19% to 22% early on, but usually capped at 18% to 20% overall |
| Occupancy | Required to live in the home as your primary residence |
Pros and cons of a home equity agreement
Pros
- No payments. Not having to make payments during the contract term means less strain on your budget and eliminates the risk of default from missed payments.
- Accessibility. Home equity agreements may be accessible to you even if you can’t qualify for a home equity loan or HELOC due to low credit or a high DTI ratio
- Doesn’t alter your mortgage. Unlike with a cash-out refinance, you don’t have to touch your current mortgage to access cash.
- You don’t have to move. You can access cash based on your home’s value without selling or moving out.
- Depreciation works in your favor. If the home depreciates, you will pay significantly less than in any other scenario.
- Could out-compete other options. A home equity agreement could be cheaper than a credit card or personal loan, under the right circumstances.
Cons
- Unknown total cost. You won’t know until the end of the contract exactly how much you’re obligated to pay.
- Lien on the home. If you’re still paying off your mortgage, the lien complicates your ability to refinance.
- Complex contracts. Most contracts are complex, difficult to fully understand, and may include features that tip the scales in the company’s favor.
- Appraisal value issues. Since an appraisal determines the value of a home, companies have a financial incentive to deflate the initial appraisal amount or inflate the home’s value at the end of the contract.
- Risk of foreclosure. If you can’t pay the lump sum when it comes due, you could lose your home to foreclosure.
- Risk of forced sale. If you can’t pay the lump sum, you could be forced to sell, and you alone would be responsible for the costs associated with the sale.
- Sharing profits, but not costs. The agreement allows the company to share in the profit earned through your home’s appreciation. But you alone must cover the taxes, insurance, repairs, maintenance and HOA costs.
- Difficult to comparison-shop. A home equity agreement can be difficult to compare with a traditional loan because the amount you’ll owe depends on the contract formula and your home’s future value.
Fees and other costs to expect
Home equity agreements come with upfront fees and costs that typically amount to 3% to 5% of the amount of cash paid out by the agreement and may include:
- Origination fees. Also called processing fees, these cover the cost of evaluating your application and creating the contract.
- Appraisal fees. Since the contract hinges on your home’s value, you’ll need at least two appraisals: one before the contract begins, and one when it ends.
-
Risk adjustments. It is common for companies to apply a “risk adjustment,” which is really a discount applied to your home’s starting value for the purposes of calculating how much you must pay. Although it’s not typically labeled as a fee by the companies offering home equity agreements, in effect that’s exactly what it is.
- For example: If your home appraises at $500,000 but the agreement uses a “risk-adjusted” starting value of $425,000, the company begins calculating future appreciation from $425,000 instead of $500,000. That means you can owe it a share of $75,000 of “appreciation” even if your home merely sells for its original appraised value.
Is a home equity agreement right for you?
Signing a home equity agreement can be a financially sound move, but only in very specific circumstances. For most people, they’re risky because they involve a lump-sum payment whose exact dollar amount isn’t disclosed ahead of time and can result in foreclosure.
A home equity agreement may be a good fit if…
- You can accept giving up some future equity (and appreciation) in exchange for cash-flow flexibility now. This tradeoff may make sense when the funds will go toward a high-priority need, and the likely cost is reasonably competitive with your available alternatives.
- You can’t qualify for a HELOC or home-equity loan. If you have significant equity in your home but your income is irregular, your credit score is low, or your DTI ratio is high, you may still be able to qualify for a home equity agreement.
- You need cash but can’t afford a new monthly payment. A home equity agreement can provide a lump sum without forcing you to stretch your budget to cover another monthly payment.
- You plan to sell your home (or have another realistic plan to cover your settlement payment). Selling your home to settle the contract is a solid plan, assuming you’re comfortable moving forward without this home. Other reasonable plans could include liquidating other investments or using future income that you feel is relatively guaranteed. Refinancing your primary mortgage may be possible, but can be tougher with the lien from the home equity agreement attached.
- You understand the contract and have a good idea of how expensive the agreement could end up being. If you’ve truly understood the contract and done the math, and you know that the potential costs are manageable for you, then you’re likely in good shape.
A home equity agreement may not be the right fit if…
- You want to remain in your home, and it’s likely to appreciate for many years. Giving up a share of the home’s future value can prove much more expensive than a home equity loan or HELOC.
- You can qualify for and afford a lower-cost financing option. A HELOC, home-equity loan or cash-out refinance is a safer, more predictable and usually cheaper way to go.
- You don’t have a clear plan to repay the agreement at the end of its term. Most people don’t have a huge lump sum of cash sitting around, so homeowners who can’t refinance can find themselves under pressure to sell their homes.
- You want to refinance your primary mortgage soon. The agreement places a lien on the property, which can complicate a refinance. If the agreement reduces the amount of equity you have, that can bar you from qualifying for a refinance.
- You plan to make major improvements to the home, and the contract doesn’t fully credit the added value to you. Different companies treat this issue differently, so research and speak with the company directly about their policies before signing a contract. You don’t want the company to “share” in home value you created and paid for yourself.
- You need only a small amount of money for a short-term expense. The upfront fees and potential share of home appreciation are a high cost that may not be justified for a small or non-essential expense.
Before you sign: a home equity agreement checklist
Before you sign, make sure you can answer these questions:
- What could I owe in several realistic scenarios? Ask the company to show the estimated settlement amount if your home’s value falls, stays flat or rises at different rates.
- What events require me to settle? Confirm whether you must pay if you sell, refinance, move out, rent the home, miss property-tax or insurance payments or reach the end of the agreement’s term.
- How will I pay the lump sum? Decide in advance whether you expect to sell, refinance, use savings or use other assets. If your plan depends on refinancing, find out how the agreement’s lien could affect your ability to qualify.
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