Sometimes, circumstances in life come along where one is sorely in need of cash, but their cash is tied up in illiquid assets. Home Equity Agreements (HEAs) provide the cash that a homeowner can access when such situations come along and their requirements are far less stringent than conventional home equity loans or refinances.
But there are significant pros and cons to consider before getting into this type of arrangement. Just as you looked at certain things when you bought your house, you should take a look at the intricacies of the hea Agreement and the benefits and risks of setting one up:
What is a Home Equity Agreement (HEA)?
What is an HEA? A HEA is a contractual agreement between an investor and a homeowner in which the homeowner receives a lump sum of cash in return for giving up a portion of the equity in the home and future appreciation on it. However, this is not a contract to be taken lightly, as the homeowner may exchange future wealth for a large sum of cash today. A typical Home Equity Agreement usually has a finite term of 10 to 20 years.
It’s one of the few financial options that allows a person to tap into their equity without taking on additional debt or selling the property. Funds from the HEA can be used for any purpose, but some lenders may restrict them until a certain amount of debt is paid off. This is particularly true if the homeowner has a low credit score or a high debt-to-income ratio.
How Does an Equity Agreement Work?
When a homeowner contacts an investor or specialty lender, the lender sends out an appraiser to evaluate the home. Upon completion, the lender makes the homeowner an offer on the amount it will pay for a certain portion of the home’s equity. If the homeowner approves the terms, the lender completes the deal and the homeowner pays the closing costs.
The lender then pays the owner a lump sum at closing and places a lien on the home for the agreed-upon amount. When the agreement expires or if the home sells first, the homeowner pays back the lender’s original principal plus a portion of any appreciation in the updated value of the home.
Homeowners must maintain the value of their property by making repairs, paying their property taxes and purchasing homeowners insurance.
If the home's value decreases over the agreement's life, the amount to be repaid will also decrease because the amount given to the lender is based on the home's value at the end of the term. If the home is not sold, the homeowner will still have to repay the original principal plus a percentage of the appreciation within that time frame.
How Much Does a Home Equity Agreement Cost?
The following fees are typical for a homeowner to pay for an HEA loan:
An Origination fee of 3% to 5% of the cash advance
Appraisal: Usually about $500
Home Inspection: Typically $350 to $500
Title Insurance: Between 0.1% and 2% of the value of the home
Escrow Services: $250 to $500
Risk adjustment: Some lenders charge a percentage deducted from the appraised value to protect the investor from future market conditions. The fee can range from 2.75% to 20% of the appraised value!
These fees add up and take a sizable portion of the immediate cash. The good news is that they can be subtracted from the equity being received rather than paid upfront.
What Are the Requirements of a Home Equity Agreement?
The requirements of an HEA are not stringent, but there are several to know:
- The home must appraise over a certain value for the contract to work
- A low credit score may restrict the amount of funds the lender will give
- The homeowner must pay closing costs such as appraisal, origination fee, title insurance, etc.
- The home must be a single-family or multifamily with up to four units. Manufactured homes, farms and apartment buildings are not eligible.
- The HEA must be a first or second lien on the home. Homes with two mortgages are not eligible.
- The home must be in a state where an HEA Loan is available. Not all states permit HEAs.
- The equity in the home must be over a certain percentage level compared to the mortgage owed
This last requirement is known as the loan-to-value (LTV) ratio, which is calculated by dividing the current loan balance by the home's appraised value and multiplying that number by 100. If the current loan balance is $200,000 and the home appraises for $500,000, the LTV ratio would be 40%.
HEA lenders typically require 20% home equity or more before granting a HEA. The usual credit score needed is 500 or better, but that’s about 120 points lower than the standard requirement for a home-equity loan or line of credit. Some homeowners might want to be able to get a home equity agreement soon after buying their home, but just like with a HELOC, it would be tough to have enough equity in the home to make it worthwhile.
Home Equity Agreement Pros and Cons
Like all financial products, home equity agreements have their pros and cons.
The pros of the home equity agreement are:
- No monthly payments are required
- A Lower credit score may not be a factor
- There is no interest paid on the principal
- It’s easier to be approved
- Few restrictions on how the money can be used
- Many HEAs do not include a prepayment penalty
The cons of the HEA are:
- It may require more home equity than the homeowner wants to give up
- The principal has to be repaid at some point or when the home is sold
- A large amount of appreciation could be lost
- The lender puts a lien on the home
- It’s not available in every state
You can see that the home equity agreement pros and cons are about evenly divided.
How To Apply for a Home Equity Agreement
Before you apply for a home equity agreement, you should ask yourself some basic questions, such as what you need the money for, how long you plan to live in the home and whether it makes sense to wait or look for a different type of financing.
Here are the steps a homeowner should take to apply for an HEA:
- Get a prequalification estimate from an HEA provider
- Shop around and compare costs, funding amounts and eligibility criteria
- Submit a full application to a provider. The paperwork needed includes a mortgage statement, proof of homeowner’s insurance and a government-issued photo ID
- Get an appraisal from the provider
- Receive the offer
- Sign the agreement
When Should You Consider a Home Equity Agreement?
A homeowner should consider getting a home equity agreement if quick cash is pressing and their income, credit scores and other finances would make them ineligible for a home equity line of credit or home equity loan. If someone has substantial income, excellent credit and other assets, they would be better off with another type of loan. The costs and sacrifices made for the HEA are otherwise just too great.
On the other hand, if your credit history is not great or your debt-to-income ratio is high, the HEA might be the best option. If interest rates are high and trending higher, the HEA might be a better alternative than a Home Equity Line of Credit with variable interest rates. No interest is ever paid on a home equity agreement.
Conclusion
A home equity arrangement is a financial product that can provide a homeowner with needed funds. The requirements for these products are less stringent than those for a regular mortgage because the home becomes the collateral for the money received and the lender risks the cash for the prospect of future appreciation.
Procuring a home equity agreement offers many benefits to the homeowner, but there are also risks and disadvantages, including high costs. Homeowners should consult with a qualified financial planner or Certified Public Accountant (CPA) before considering a home equity agreement.