Lew Sichelman
There comes a time in practically every homeowner’s life when they consider using the equity they’ve built up in their house for one purpose or another.
Perhaps it’s to pay for their kid’s higher education. Maybe they want to enlarge the place to accommodate a new arrival. Or maybe they lost their job, have no immediate prospects for a new one, and need some cash to tide them over.
Typically, homeowners in these situations would turn to home equity loans or lines of credit. But a relatively new type of financial instrument, the home equity contract, is growing in popularity.
Proponents say that HECs, sometimes known as home equity investments, involve no monthly payments and are not even considered debt. But federal regulators are taking a hard look at these tools and are warning consumers to do the same.
“Home equity contracts carry features that echo some of the risky loan structures that were common in the lead-up to the 2008 housing crisis,” states a January report from the Consumer Financial Protection Bureau.
What’s a Home Equity Contract?
If nothing else, HECs are expensive, even compared to other home-secured finance options. They may require consumers to pay hundreds of thousands of dollars at the end of their loan terms, depending largely on how much their homes have appreciated over that time.
HECs are deals in which homeowners receive an up-front payment that must be repaid at the end of a predetermined term – usually somewhere from 10 to 30 years – or when they sell or move out of the home. Owners retain the right to occupy their places and are still responsible for all the ongoing expenses, including taxes, maintenance and insurance.
Only about 40,000 or so HECs have been written to date, mostly by just four companies. But the market is said to be growing, with more deals originating every month.
Each company’s products are similar, but they differ in the fine print, making it difficult to comparison-shop. So far, consumer complaints about HECs to the CFPB have been limited, but the financial watchdog agency has its eyes on the business.
“Overall,” the agency said, “the lack of adequate understanding among consumers about home equity contracts, their complex terms, non-standardization in disclosures and other issues may prevent consumers from recognizing the true financing costs and risks of these products.”
One of the problems is that most HECs on the market don’t have income or employment requirements. Nor do they require high credit scores. The companies offering HECs emphasize the large, up-front cash payments and the speed of funding. They also stress that no interest is charged, no monthly payments are necessary and that the deal is not a loan – and is therefore technically not debt.
But it is debt in the sense that, eventually, it must be paid back – and it’s often an exorbitant amount you may not be able to afford, even if you sell your house at a profit.
Key Features
Here’s a look at some of the key features of HECs.
The amount you receive up-front is based on how much equity you currently have in your property. You are responsible for paying any closing costs, including processing fees, to the HEC company, and for covering third-party costs like appraisal and recording fees.
The more your place appreciates, the more you’ll have to pay back. And the house’s starting value is often discounted, sometimes by as much as 25 percent. The payoff, then, would be the difference between the discounted starting value and the final (undiscounted) value, as determined by an appraisal at that time.
HEC companies generally require to be paid back a multiple of their initial payment. For example, if you receive a payment worth 10 percent of your home’s current value, the HEC company may demand to be repaid 20 percent of its value on the back end – meaning “the company would double their money before factoring in any home price appreciation,” writes the CFPB.
Some companies credit you for home improvements that increase its value, but others do not. And when the house is sold, the owner is solely responsible for all selling costs.
Some companies use rate caps to limit how quickly the repayment amount can grow. While they are marketed as a consumer protection, “rate caps are mathematically equivalent to a maximum interest rate on the initial payment to the homeowner,” the CFPB said.
Why an HEC Might Not Be for You
Here’s a simplified example of a typical HEC from the consumer watchdog agency
Say your house is worth $500,000, and you get a cash payment of 10 percent of that ($50,000). In exchange, the company takes a 20 percent interest in the house. The contract has a 20 percent annual return cap. You have a 30-year, fixed-rate mortgage at 4 percent; there are 25 years to go and a $300,000 balance.
You’re responsible for the HEC transaction fees – 4 percent would be a typical rate, which equates to $2,000 – and third-party fees, which could easily be another $2,000. So right off the bat, your proceeds are reduced by $4,000.
Let’s say the house appreciates at 6 percent a year, which is a tad higher than the historical average. If you sell your place in three years, you’ll owe the HEC company $86,400. That’s the equivalent of having gotten a zero-payment loan with an annual rate of 20 percent.
If you wait 10 years to sell, you’ll owe a whopping $179,085.
Because the company’s returns are boosted by the discounted initial value of the house and by the multiplier, the odds are stacked against you. And if your contract period runs out and you cannot pay in full, in a single lump sum, you could be forced to sell your place.
Lew Sichelman has been covering real estate for more than 50 years. He is a regular contributor to numerous shelter magazines and housing and housing-finance industry publications. Readers can contact him at lsichelman@aol.com.
