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Could a Shared Equity Mortgage help the real estate market?

Real Estate Broker/Owner with Complete Florida Realty

I had been pondering the effectiveness of one of the government's recent "bailout" plans called Hope for Homeowners after reading several articles and speaking with several mortgage professionals. Everyone was pretty unanimous in their opinions that the entire program has thus far been a failure. You can check out the details of the plan here http://portal.hud.gov/portal/page?_pageid=73,7601299&_dad=portal&_schema=PORTAL . Many have said it's a failure due to the restrictions placed on those who must qualify for the program; being only for primary residences, the need for the current lender to agree to a write down of tens of thousands on their loans without any incentive, mortgage insurance required above and beyond normal, and a "shared equity" payback of future home appreciation to the government should the homeowner ever sell.

                This blog isn't about why the program failed though, I was actually thinking about what idea's of the program were actually pretty good, and could have the potential to help the current housing market, and help curtail future lending abuses. Specifically I like the idea about a shared equity mortgage or SEM, and I'll tell you why.

                I can see an SEM as the mortgage of the future, or at least of the near future. In exchange for a lower interest for a home purchaser/refinancer, a bank could ask the homeowner to share a part of the future appreciation the house may see. The homeowner gets a below market interest rate of say 3% instead of 6%, making the home payments much more affordable, and the bank get's a potentially bigger payoff on the back end of the loan. On the surface this may look like it goes against the two sides best interest, (after all why would a bank want to shift getting paid on the front end of the mortgage to the back end, and why would a homeowner want to share in their good fortune with the bank?) but if you look deeper, the true benefits can be seen.

For the lenders it makes sense because they can offer rates lower than their competitors with such a mortgage, while still making a great profit over the long term. They would also have more incentive to hold their mortgages instead of sell them. Instead of having only the upside of being paid 6% for the next 30 years on a continually declining principal balance, they could be making half of the appreciation on the full value of the home. Meaning the way mortgages are currently set up, banks make less and less money the longer the mortgage is held, but with an SEM they would potentially be making more and more the longer the mortgage is held.

The example below explains what I mean:

Imagine a house with a purchase price of $103, and the buyer puts $3 down on his mortgage.

In Year 1, $100 is owed at 6%. The lender earns $6 of interest, and the owners' mortgage payment is $9

In Year 2, $3 has been paid off with $97 owed at 6%. The lender now earns $5.82 of interest

Skip forward to the final year of the mortgage and only $3 is owed and the interest rate is still 6%. The lender at this point is only earning $0.18 in interest.

What I'm basically trying to show is the diminishing returns for the bank. They make money on the front of the loan instead of the back. (not meant to be a 100% accurate representation of an amortization schedule)

Now let's look at a shared equity arrangement:

The same house is purchased for $103, and the buyer puts down the same $3

In year 1, $100 is owed at 3%. The lender earns $3 of interest and the owners' mortgage payment is now only $6. But to limit the banks risk at the beginning of the mortgage the bank keeps 100% of the equity including the $3 put down. On paper the bank is still making $6

In year 2, $3 has still been paid off (for the examples' sake) and $97 is owed at 3%. The lender get's $2.91 of interest, BUT the house has also appreciated 3% in value over the year before to a value of $106.09. The lender now has a 95% shared equity stake of $6.09 (the owner paid down $3 of loan and gets to keep 100% of that equity so the lenders' base is constant at $100), so on paper the lender has $2.93 in equity plus 2.91 in interest totaling 5.84, a higher return already in year 2 above than the example before.

Extrapolated out to year 30, $3 owed at 3% and the lender earns $0.09 in interest, but the home is now worth $242.72 (assuming a constant 3% gain a year) the bank only made half of what it would have otherwise in interest payments, but the home in that year has appreciated by $7.07 and the lender has a 50% stake in that appreciation, or $3.53. Big difference for the bank versus getting only 18 cents!

This of course is an over simplified version for example's sake, but doing the real numbers on a 103K purchase price with a 100K loan, the bank on a normal loan at 6% over 30 years would make about 115k in interest payments. The same loan at 3% would only make about 52K in interest payments but have a potential to make another 71K by sharing half of the homes appreciation (assuming 3% annual appreciation) totaling 123K; a return that could have only been reached by charging 6.3% on a normal loan. Admittedly this is not that great of an incentive for the lender to make their money on the back end instead of the front end, but with some FHA backing and insuring, I'm sure the banks could be convinced of the SEM's profitability.

For the homeowner it makes sense because they can get a much more affordable mortgage, in the example above it cuts the mortgage payments by 30%! This has the bonus of making the cost to benefit analysis of renting vs. own that much more convincing to own, especially at today's prices, and could help jumpstart buying in today's market. I don't know about you, but if I could receive the benefits of a much lower payment now in exchange for a possible equity sharing later, a payout that only happens IF my home appreciates and I make money too, I'll choose the latter every time!

Looking at a home as an investment, owners are limiting their upside potential by sharing future equity, but their downside risk in the short term is greatly reduced with lower payments, and further downsides could be mitigated with an agreement with the lender that shares potential losses on a sale as well. A serious investor looking to cash flow as many rental properties as possible should seriously consider such an arrangement as it relates to their investment goals.

Looking at a home as a home, a place to live, the SEM a no-brainer. If someone lives in their home for a long period of time, they can save tens of thousands in interest with the lower rate. Savings they can put into their retirement accounts or children's college funds today, instead of having that money locked up in their home.  There is also a greater incentive to own homes long term, under the H4H program 100% of appreciation is paid if the homeowner sells in the first year, 90% in the second, and so on, until after year 5 when the equity sharing stops at a minimum of 50%, so it makes sense that someone with one of these loans would want to stay in their home until they max out their ability to retain the highest portion of their equity they can. This also helps to keep people from thinking short term when it comes to owning real estate, speculating or flipping real estate doesn't make much sense if you will be giving away a large chunk of your equity in the first few years. For those that never plan on selling their home, the mortgage would be structured like a partnership. A partnership that ends either when they sell the house or the mortgage is paid off. In the event of a payoff, an appraisal is ordered and the lender's portion of equity is "frozen" until the eventual sale of the home. Bringing up another potential benefit, if home prices start falling, similarly to what has happened recently, those with the ability to pay off their mortgages will do so to freeze the lender's equity share. Thousands of homeowner paying off their mortgages at the same time....now that's a capital injection that would out rival anything we've seen from recent bailouts.

For those that wish to refinance, it's just trading one partnership for another, one must pay off the old partner their equity share, and the new partner starts from even establishing a new base line. Second mortgages can act the same way, the homeowner would simply be limited to taking out only their portion of equity.  Home improvements could get tricky, but at a minimum, any cash a homeowner puts into their home for upgrades would be credited to their portion of equity.

                For society as a whole it makes sense because lenders and borrowers will truly be partners in the ownership of real estate. Lenders will have more incentive to underwrite their loans to higher standards, and more people will be able to become homeowners with a stake in their communities' welfare. Plus in the short term it would really jumpstart the housing market, and give incentive to banks that hold loans that are upside down to modify them to a SEM with a starting principal down at today's values.

                Over the long term who knows if an SEM would prove profitable enough for lenders to offer, or popular enough with the public. I can see potential harm if another bubble is created by extremely low interest rates that may cause home values to spike, and when that bubble bursts and lenders run away from SEM's (they would no longer be making any appreciation on the back end), the burst could be even deeper than this one! These risks could be minimized however with the same cautions that could have minimized the current burst, lenders being diligent and conservative as to the real value of real estate vs. how much they will lend, and cautious underwriting (like qualifying the borrower as if they were paying a market rate of 6% even if they were getting an SEM at 3%).

In the end, I think we have nothing to lose by experimenting with this type of mortgage over the next 2-4 years. Lenders could establish logical underwriting guidelines with a little research, and the government can pioneer the first mortgages through the FHA and/or VA easily. It would cost very little to implement, and wouldn't be considered a bailout since anyone could qualify for such a mortgage.

What do you think?

Would you consider an SEM?


John Hawley

Very good way to boil it down, and I agree with almost all of your comments.  I think you'd be hard-pressed to find a lender willing to take the downside risk AND offer loan at a reduced rate.  There are a host of other complications such as determining the value of home upgrades and such, but nothing that is not workable.  They are doing this in the UK and Australia (private markets).

Feb 17, 2009 07:47 AM