by BLACK ENTERPRISE Editors
With many households being asset-rich yet cash-poor, having potentially millions trapped in real estate equity while everyday costs rise is frustrating.
Homeowners in the U.S. have relied on two familiar methods for accessing their housing wealth, otherwise known as equity, in the past. Those two methods are home equity loans and home equity lines of credit. However, the interest rate environment in the last couple of years has been less than favorable for these options due to elevated rates. With many households being asset-rich yet cash-poor, having potentially millions trapped in real estate equity while everyday costs rise is frustrating.
Luckily, a relatively new way of accessing that capital has emerged. Equity-sharing agreements are a unique method of accessing cash without taking on monthly payments, though they can seem confusing on the surface. In this story, Splitero breaks down the concept, including how it works, the benefits and drawbacks, and whether it might be the right fit for your needs.
Understanding Traditional Home Equity Options and Their Limitations
Understanding the benefits of equity-sharing agreements starts with understanding the ins and outs of traditional home equity options and their limitations.
Home equity loans and HELOCs
Cash-out refinancing challenges
There’s another traditional home equity option that is lesser known: cash-out refinancing. This strategy involves replacing your existing mortgage with a larger one and pocketing the difference. This has become less popular as most homeowners today hold historically low-rate mortgages from either before or during the COVID-19 era. Swapping into a higher interest rate environment today makes little sense, leaving homeowners trapped as equity-rich yet not able to become liquid.
What are home equity sharing agreements?
A newer concept is equity sharing agreements, often called home equity investments or home equity agreements. These methods can potentially solve the issue homeowners are facing. As with any type of financing agreement, it can be right for some, whereas it may not be the best choice for others.
Definition and basic structure
How they work
Every company offers variations, whether in funding amounts, term lengths, or exit options. Certain companies place an emphasis on flexibility, whereas others place an emphasis on minimizing fees. This is why researching different options before choosing a provider is crucial.
Traditional loans vs. equity-sharing: Key differences
Traditional loans and equity-sharing can seem similar at first, but there are a number of key differences, both in financial structure and requirements to qualify:
Financial structure comparison
As outlined by Investopedia, equity financing and debt financing are two distinct concepts, with the crux of it all revolving around ownership percentage.
When financing with a traditional debt product, there is a repayment obligation you are entitled to meet after borrowing money. However, when financing with equity, you are essentially selling the option for an investor to purchase a portion of your ownership in the home within a set time period.
The primary benefit of equity financing is that there are no monthly payments, meaning your ongoing cash flow won’t be as tight as it would be with debt financing.
Qualification requirements
Given that traditional loans rely on repayment, qualifying often requires strong credit, sufficient income levels, and a favorable debt-to-income ratio. Equity-sharing agreements, on the other hand, focus more on the value of the property you are putting up and its potential appreciation over time. This means that even if you have a lower credit score or irregular income, you could still potentially qualify.
Benefits of equity-sharing agreements
Making the choice between traditional debt financing and equity financing should require careful evaluation of your own personal financial standing, including all your assets. Generally, there are three primary benefits of equity-sharing to consider:
Immediate Financial Relief: You will receive a large sum of cash without adding monthly payments to your finances, which can be life-changing during periods of financial strain.
Risk-Sharing Advantages: Since an investor in your home’s equity shares in the downside risk, you aren’t the sole party burdened if the property value falls.
Flexibility Benefits: Most equity-sharing agreements don’t place restrictions on how the funds can be used, whether that be college tuition, medical costs, debt payoff, or another purpose.
Risks and Considerations
As with any other type of financing, there are always downsides to keep in mind which may not make it the right option for you:
Cost Analysis: If your home appreciates sharply, the portion that is owed to the investor can sometimes far exceed the interest that a complementary loan would have charged you. However, most equity-sharing agreements have a safety cap in place to protect you from high appreciation.
Regulatory and Legal Concerns: Equity-sharing is still a newer financial product that has evolving oversight, so any homeowner should read an agreement carefully and defer to legal counsel when necessary.
Potential Downsides: There is always the risk of reduced future profits via home appreciation. If you choose to sell and the price has risen significantly, your portion of the profit will be less than it otherwise would be.
Real-world scenarios: When equity-sharing makes sense
Adding context to how equity-sharing agreements can benefit you in a real-world sense can provide some additional insight into whether financing with equity is right for you.
College Tuition Funding
Medical Bill Consolidation
High-Interest Debt Payoff
Finally, those with large amounts of high-interest debt can utilize equity-sharing agreements to reduce payments. By using the lump sum received via the agreement and putting it towards paying down all high-interest debt you have, you can effectively reduce your outstanding debt balances to one single interest rate and sum.
Making the Decision: Is Equity-Sharing Right for You?
Equity-sharing agreements may not make sense for certain situations, whereas they may be perfect for others. As outlined by Bankrate, there are certain individuals and situations where equity-sharing makes the most sense.
The most common candidate for equity-sharing is someone who is cash-poor, house-rich, meaning they have a valuable property but don’t have many liquid assets. Similarly, homeowners who have a large amount of home equity, but lack the credit history to acquire a competitive and affordable loan, may benefit.
Anybody who has an unsteady income stream or fixed income that doesn’t allow them to afford additional monthly payments may find equity sharing to be a useful path as well. On the other hand, those who have good or excellent credit may be able to qualify for low interest rates that make additional monthly payments manageable, potentially making the long-term cost cheaper than an equity-sharing agreement.
Questions to Ask Before Signing
Consider some of the following questions if you are still on the fence about whether an equity-sharing agreement is the right path for your finances:
What share of future home value are you potentially giving up?
What are the total fees, closing costs, and exit early penalties, if applicable, of the agreement?
What is your home’s value determined to be at both the entry and exit point of the agreement?
What are your options if you want to refinance or remodel your home?
What are the long-term costs of a traditional financing model vs. an equity-sharing model?
Alternative Options to Consider
Several options are available for homeowners looking to access their home’s equity:
Home Equity Line of Credit (HELOC): A revolving credit line secured by your home, allowing you to borrow, repay, and borrow again up to a set limit, similar to a credit card.
Home Equity Loan: A fixed-rate loan that lets you borrow a lump sum against your home’s equity, which you repay over time with regular monthly payments.
Cash-Out Refinancing: A refinance of your existing mortgage for a higher amount, allowing you to receive the difference in cash while replacing your current loan with a new one.
Reverse Mortgage: A loan that allows homeowners 62 and older to borrow against their home’s equity without making monthly payments. The title remains in your name, and the loan is repaid when you no longer live in the home. The most common type is a Home Equity Conversion Mortgage (HECM), as outlined by the Consumer Finance Protection Bureau. As the loan balance increases, your equity decreases, and the loan is typically repaid by selling the home.
Future Outlook and Industry Trends
Equity-sharing agreements as an option for your financing needs
Equity-sharing agreements now represent an alternative path to traditional methods like a home equity loan or home equity line of credit. Serving as a hybrid model that monetizes your wealth while sharing risk, it’s a fantastic choice for anyone who has a vast sum of equity but limited liquidity.
No financing is without risks, though, which is why you need to evaluate the overall cost, depth of the contract, and your own personal finances before making a choice on whether traditional debt or equity financing is best for you.
This story was produced by Splitero and reviewed and distributed by Stacker.
RELATED CONTENT: The Hidden Home Equity Tax Straining Families For Staying In House Too Long
Source: Black Enterprise
