Saving enough for a down payment on a home can be a challenge for many first-time homebuyers. And asking parents or family members for a low- or no-interest loan can be difficult because it means they could lose the chance to invest the funds and earn a good return on their money. But there is a way around the dilemma. A new type of shared equity mortgage (SEM) allows a parent, family member, or other to become a co-investor in your property.
By providing a percentage of the down payment, a co-investor can participate in a percentage of the property’s increased value at resale. Of course, as with any investment, there’s also the risk of losing money if the home goes down in value. But, over the long-term, real estate has historically been a sound investment. And for parents looking for a way to help their kids buy a home without sacrificing their investment funds, a SEM can be just the answer they’re looking for.
How SEMs work
When investors buy shares in a company, they expect to see a profit when the business grows. Shared-equity mortgages are based on the same idea: an investor, often a parent, helps a new homeowner by contributing some or all of the down payment needed to qualify for a traditional mortgage. In return, if the house is later sold at a higher price, the investor gets his original stake back, plus an agreed-upon share of the gain. When done properly, a SEM is a win-win arrangement.
Here’s an example: Ursula and James want to buy a $200,000 house, but they have just $10,000 for the down payment. While they could qualify for a mortgage, their interest rate would likely be higher than if they were to put more money down. Plus, if they made a down payment of less than 20 percent ($40,000), they would also incur the added cost of private mortgage insurance.
Ursula’s mother, Laura, suggests another plan. She will lend them $30,000 (15 percent of the home’s value), allowing Ursula and James to make a 20 percent down payment. The couple will not have to pay any interest on this loan as long as they own the home. When they eventually sell -- hopefully for more than they paid -- they will pay Laura 15 percent of the sale price, plus 20 percent of the gain. If they sell in five years and the house appreciates about 6 percent annually, here’s how things would work out:
Purchase price: $200,000
Sale price: $270,000
Net gain: $70,000
Laura’s equity share: $40,500 ($270,000 x 15 percent)
Laura’s 20 percent of gain: $14,000 ($70,000 x 20 percent)
Laura would receive $54,500 when the sale closes, which represents an annual return of more than 12.6 percent on her $30,000 investment. Meanwhile, for the last five years, Ursula and James would have kept their monthly payments as low as possible while still building equity in their home.
What are the risks?
Like any financial arrangement, SEMs carry some risk. If the market drops and the homeowners sell for less than they paid, the investor will lose money.
In our example above, if Ursula and James were to end up having to sell for $180,000, Laura would lose $7,000. This is because her equity share would drop to $27,000 ($180,000 x 15 percent) and she would also absorb $4,000 of the net loss: ($200,000 - $180,000) x 20 percent.
A SEM also carries a cost for the borrowers. If the home shoots way up in value before they sell, the amount they pay back to the investor may be larger than what they saved in the first place. If Ursula and James sold their home for $350,000 after five years, for example, they would owe Laura $82,500 ($350,000 x 15 percent plus 20 percent of the $150,000 gain).
SEMs are private agreements between borrower and investor, and misunderstandings (or dishonest dealings by one party) can be extremely costly. For example, if the investor is named as a co-owner of the property, she is legally responsible for a share of the property taxes, liens or other obligations, and her credit will be damaged if the mortgage goes into default.
In addition, without a contract there is nothing to prevent the borrower from reneging on the deal when the house is finally sold. That’s why it is always a good idea to get legal advice when arranging a SEM, even when it involves close family members.