Shared equity mortgages (SEMs) are not well-understood in the U.S. They made a brief appearance here, only to disappear during the Great Recession. However, they are slowly coming back into the American housing market. Here's a quick rundown of this less-common mortgage product.
Normal home equity mortgages involve liens secured by the equity in your property, that is, past home appreciation plus whatever dent you have made in paying down your home's principal balance. Home equity is your property's value less the value of all liens against it. SEMs are transactions secured by anticipated future appreciation in your property. Whatever home equity you own prior to the transaction is not involved at all.
How SEMs Work
SEMs aren't technically mortgages at all; they are options. The lender pays you an agreed-upon sum based upon the current value of your property, generally between 8% and 16%. When you sell your property or otherwise terminate your agreement, the lender (or more correctly the investor) is entitled to an agreed-upon percentage of your property's appreciation, typically between 50% and 100%. Equity Key, a major player in the SEM market, determines the appreciation not by the property's sales price, but instead by the appreciation published in the S&P/Case-Shiller Home Price Index for your area.
A couple with a $400,000 home would like to send their child to college and needs to pull the money out of their home to do it. Under an SEM arrangement, they are offered 12% of the property's value in exchange for 75% of its future appreciation. The homeowners get $48,000 for their child's college expenses. In 10 years, assuming that the Case-Shiller Index determines that property in their area appreciates at a 4% annual rate (compounded annually), their home will be worth $592,098. If they sell their home at that time, they owe 75% of the $192,098 ($144,073) to the investor. So it cost them $96,074 ($144,073-$48,000) to borrow $48,000 for 10 years. That's comparable to a home equity loan at just over 11% compounded monthly...If you could get one that didn't require monthly payments.
However, if your home did not appreciate (unthinkable until a couple of years ago, but today a distinct possibility), you would owe nothing. Zilch. Nada. For those who need the breathing room, the idea of 10 years with no payments has its appeal. For borrowers with questionable credit or insufficient income, a SEM may be your only option to leverage your home.
The Fine Print
SEMs aren't for everyone. In fact, they are probably appropriate for only a small segment of the market. Many SEM investors impose age restrictions on their borrowers. For example, Equity Key requires that borrowers be between 55 and 85. Some may put health restrictions on their homeowners because a life insurance policy may be involved (it would repay the loan if you die before selling your home).
In addition, an option is treated differently by the IRS than the proceeds of a loan. You may have to report it as ordinary income in the year it is received or as a gain when the investor exercises it; consult a tax advisor before getting involved.
Yet, the most onerous requirement of an SEM is that you have to retain possession of your property for a very long time. Equity Key assesses stiff penalties if you sell within 10 years (you don't have to live in the property, but you must retain ownership). The penalty is the larger of:
- The amount paid for the option plus three percent of the property's value when the transaction took place, plus 12% per year on that amount;
- The amount of appreciation the investors are entitled to at the time of breach.
So you don't want to trigger those hefty charges. Furthermore, who knows with any certainty what will happen over that time?
The Bottom Line
For most people, especially those still in their prime earning years, a home equity loan is far cheaper and less restrictive than a shared equity mortgage. You can pay college tuition, fund home improvements or retire expensive debt more cheaply and with fewer hassles when mortgage rates are low. For those who are older and have income challenges, a home equity conversion mortgage (HECM), also called a reverse mortgage, may offer more benefits and cost less. SEMs probably only benefit those with too little equity to get a reverse mortgage and too little income to qualify for a home equity loan.
More help from HSH.com
Home equity borrowing basicsOur new Guide to Home Equity Loans and Lines of Credit (HELOCs) starts here.
Accessing your home equityThis first article of Section II of our Guide to Home Equity Loans and Lines of Credit looks at the various ways lenders allow you to access your home equity, and discusses key differences between loans and lines.
Determining how much home equity you can borrowArticle 3 of Section I of HSH.com's Guide to Home Equity Loans and lines of credit, we explain how to reckon your equity stake and discuss criteria lenders use to decide how much they'll lend to you.
Using home equityThis is the second article within Section I of HSH.com's Guide to Home Equity Loans and Lines of Credit. In it, we discuss some common and valuable uses of your home's equity, and some you may want to avoid.
Understanding home equityThis is the first article within Section I of HSH.com's Guide to Home Equity Loans and Lines of Credit. In it, we explain what home equity is, how you get it, how you can build it and why you should protect it.