Meet The Parents-Backed Mortgage
David Ragan and his wife, Jocelyn, own a starter home they bought three years ago for $125,000 in a new subdivision in a rural area some 15 miles outside of Denton, Tex. Since then, their children—James, 2, and McKenna, seven months—have joined them, and the house is getting crowded. The Ragans would like a bigger home in a more established neighborhood in Denton with good schools. Such a house might cost at least $180,000, which is a stretch.
So Ragan, a certified financial planner, is working out a deal with his father, Gerry, who will become an investor in his yet-to-be-purchased home. The agreement, called a shared equity financing arrangement or a shared equity mortgage, is an increasingly popular way for family members, usually parents, to help their children meet today's home prices.
The final terms still need to be worked out, but this is the framework: Dad will put $50,000 into the down payment, and the Ragans may add to it depending on the proceeds of the sale of their current home. Either way, the equity sharing will allow the couple to purchase the more expensive place without stretching their finances. Dad will get his investment back plus a share of the appreciation determined by his stake in the purchase price. If the Ragans buy a $200,000 home, then dad's $50,000 investment gets him 25% of the gain. "This allows my family to live in a better neighborhood that we could not have otherwise afforded," says Ragan. "It allows my father to participate in real estate appreciation without going out and purchasing something himself."
True, home prices are down 2% nationally over the past 15 months, but that hardly makes housing more affordable for young families. The nation's median home price has doubled since 1993, to $212,800, and in many parts of the country the figure is much higher. For instance, in San Francisco and Oakland the median price of a home is $737,000. The comparable figure for the New York City metropolitan area is $470,000. Even in Denton County, Tex., it's just shy of $159,000. "We have a lot of older clients who say they're interested in helping out their kids," says Jared Roskelley, a certified financial planner in Scottsdale, Ariz. "And the kids tell us they're interested in getting help from their parents."
A SAFER BET
The shared equity deals can be a prudent alternative to some of the more creative financing techniques of recent years. Many young homeowners who took on interest-only mortgages, piggyback loans, option adjustable-rate mortgages, and other such gimmicky products are finding themselves financially stretched as the cheaper teaser rates expire and higher market rates kick in.
In sharp contrast, equity-sharing deals offer the homeowner a fiscally conservative package. Investors, usually parents, typically put in cash to allow the buyers to amass a down payment of at least 20%. That allows buyers to qualify for a conventional 30-year, fixed-rate mortgage. The equity sharers get back their initial stake plus 10% to 50% of the profits.
These deals are flexible. Typically, a written contract spells out that the homeowner is responsible for mortgage payments and gets the tax deduction that comes with it. Who pays the property taxes needs to be worked out between the homeowner and investor. (Ragan and his dad plan to split them 50-50.) Many equity lenders insist on an end date, when the investment will be paid back either through a sale or a refinancing.
In some cases, the parent's name is on the loan, and in others it isn't. For instance, Ragan's father's won't be on the mortgage, and their agreement won't include a date for dad to get his money back. "Everything is open to negotiation," says Virginia Gerhart, a certified financial planner in Northern California's pricey Marin County. "That's why you should have an attorney involved."
Indeed, parents and children need to exercise caution. For one thing, advisers say parents shouldn't even think of investing this way if it means putting their retirement funds at risk. There's always the chance of no appreciation. Most important, parents shouldn't let their emotions cloud their financial judgment.
The price of love can be steep. Look at the experience of one of Roskelley's clients. She's a 60-year-old divorcée living on investment income. Several years ago she gave her daughter $40,000 as a down payment for a first home. The mother expected that she would get back the $40,000 plus 20% of the profit when the home was sold, but the agreement wasn't in writing. A few years later the daughter sold the home, but instead of repaying her mother she loaned the money to her boyfriend, who was starting a business. The relationship went bust, as did his business, and no money was recovered. The arrangement, says Roskelley, "left the mother and daughter at odds with each other."
At the moment, shared equity financings are largely ad hoc legal agreements negotiated between well-off parents and their young adult children. There was an attempt in the 1970s to popularize "shared appreciation mortgages," but they never took off because the terms were unfavorable to investors.
In the next couple of years a more formalized shared equity arrangement could get new life. At least that's the vision motivating real estate scholars like economist Andrew Caplin of New York University. He and a number of other experts are designing standardized shared equity mortgages that would allow outside investors to buy a piece of the equity gain. Caplin estimates that about 25% of first-time home buyers could find such arrangements attractive. When they do come along, investors in it for the money will extract stiffer terms than mom or dad.
In the meantime, well-heeled families continue to negotiate their own deals. Done right, it's win-win financing.
By Christopher Farrell