Americans are debt consumers. Often, we consider debt just an inevitable part of life: buying large items like houses, cars, and financing education requires more money than most Americans bring home in a year.
According to the Federal Reserve Bank of New York, household debt totals $13.5 trillion as of September 30, 2018, and mortgage debt represents the majority of household debt at $9.1 trillion.
That said, financial advisors often say that homeownership is an important path to building wealth in the U.S., one that can put a person in a much better financial position, especially from a retirement perspective, over a lifetime when compared to renting.
However, not everyone is financially able to purchase a home through a mortgage with 20% down – and not every mortgage is structured the same way. One of the biggest decisions we face is if and when to jump into the pool of mortgage debt, and which way to do so.
If we were able to predict what would happen in the future, not only would we be rich lottery winners, but we would also know the best path to take when it comes to buying a property or renting until the financial “time is right.” We can’t predict the future, but we can look backward with actual data and forward with predictive analytics and use that information to help in our home-buying decision-making process.
There are three defined dwelling paths for borrowers: renting, buying a property with a traditional low down payment mortgage, and buying a property using a shared-equity (also known as shared appreciation) mortgage.
This third option, less well known than the other two, is an arrangement in which a borrower purchases a property in conjunction with a shared-equity lender (or investor), who provides part of the down payment. The borrower and lender share in the home’s upside value or downside value at the time of the sale of the property.
Using historical information, let’s take a retrospective look at these three options for a hypothetical borrower, and how this person would have fared under a certain set of realistic conditions.
According to a recent survey conducted by the Harris Poll on behalf of Trulia, nearly all U.S. renters who say they wish to buy homes perceive barriers to homeownership that include not having enough funds for a down payment, and credit concerns in qualifying for a mortgage.
Other obstacles include not being able to pay off student debt, as 26% of renters 18 to 34 years old are burdened by student loans. For these reasons and others, 60% of the survey participants that are prospective home buyers said they planned to wait more than two years to purchase a home.
Waiting to buy a home has its downside as well. Spending $1,500 a month for five years (with rent increases) may cost close to $95,000. And, at the end of that five years, the renter walks away with no asset in hand, whereas buying a home results in owning an asset (in most cases at the end of the mortgage term).
To evaluate the best path to follow, we will look at two types of mortgages: a traditional mortgage, which requires a minimum 3% down payment, and a shared-equity mortgage, which requires a minimum 5% down payment, and compare those options with renting. This analysis will focus on the costs and benefits of optimizing the minimum requirements for each path.
Traditional Mortgage with Limited Savings
Many options are available to borrowers with limited down payment funds. These options include Federal Housing Administration (FHA) mortgages, where the borrower puts down a 3.5% down payment (or obtains a gift for those funds), as well as a conventional mortgage, with 3% down payment from the borrower’s own funds.
Other programs include state and local housing programs, as well as credit union low-down-payment programs. These programs require mortgage insurance or increased rates to cover the cost of risk exposure for the investor.
It is important for the borrower to evaluate these programs and find the best fit as it relates to that person’s financial status and future plans for staying in the home.
Shared Equity: Sharing the Ups and Downs
The history of shared-equity mortgages is quite deep. While not commonly offered in the United States, shared-equity mortgages were used quite a bit in the United Kingdom in the late 1990s. Interestingly, however, these types of mortgages were also considered as a loss mitigation solution in the U.S. for borrowers who needed their loans restructured, to assist them in making their mortgage payments after the financial crisis.
For example, in the state of New York, the terms of the shared-equity modification allowed for the lessor of the reduction in principal offered to the borrowers, plus interest at the modified rate, or 50% of the amount in appreciation in value of the property.
Other shared-equity loss mitigation programs such as FHA’s Hope For Homeowners (H4H) were introduced after the global financial crisis to assist homeowners. These programs were somewhat complex and did not achieve substantial volumes.
How Shared Equity Works
In a shared-equity arrangement, the lender is an investor in the transaction. When the value of the property changes, there is a risk/reward trade-off for both the borrower and the lender/investor. To help understand a shared-equity arrangement and how movements in future house prices may impact a borrower’s bottom line, we will look at two different market scenarios.
In our example, we will evaluate the terms of a shared-equity mortgage lender/investor’s agreement. The lender offers to invest a 15% down payment along with the borrower’s 5% down payment. However, the 15% down payment must be repaid as part of the future shared appreciation (or depreciation) division of funds (that is, the home’s increase or decrease in value).
In exchange for investing the down payment, the shared-equity lender/investor requires 52.5% of the upside of the property value or covers 52.5% of the downside at the time of sale. Conversely, the borrower retains 47.5% of the upside of the property value (or covers 47.5% of the downside) at the time of sale. The terms of the shared-equity arrangement below were derived from a shared-equity company’s website.
|Down payment||15%*||5% initially (+15% repayment of down payment at time of sale)|
|Shared up or down percentage of property price change at time of sale||52.5%||47.5%|
* Borrower must repay the 15% down payment at time of sale.
How do these three paths (rent vs. buy vs. shared equity) compare in a real-life scenario?
Each of these three paths presents a very different financial picture to a potential buyer. Using historical data, we can evaluate how the risk of home price decline in a shared-equity arrangement compares to using a traditional mortgage program, or renting.
Using this information we can examine how the rent versus buy decision can help prospective borrowers understand the potential impact of buying a home on their long-term finances. Layering on a shared down payment and appreciation component to this analysis adds another consideration for affordability and overall costs.
Path 1: We will model a traditional mortgage scenario in which a first-time home buyer with limited savings does not have enough funds for a large cash down payment (typically 10% to 20%), but the borrower qualifies for a 3% down payment or 97% program with mortgage insurance. The 3% down payment programs are the most popular for first-time home buyers and those with very limited funds.
Path 2: For our shared-equity scenario we will look at a 20% down payment mortgage with a shared-equity component (15% down payment paid by shared-equity lender, 5% minimum down payment requirement paid by borrower).
Path 3: We will compare these two mortgage options to someone who rents for that same time period, with an annual rent increase of 2.5%. We estimate an up-front rental fee of $200 plus one month’s rent for this scenario.
We explore these three different dwelling paths using two actual home price scenarios; one in which a borrower purchased the home just before the global financial crisis and sold it five years later, and one where the borrower purchased the home after the crisis and sold the home five years later.
Figure 1 shows the comparison for the mortgage payment and down payment expenses for the shared-equity loan, the 97% loan, and renting a home. The mortgage interest rate is 4.5% for 30 years (the rate is 4.625% for the 97% mortgage as loan level risk pricing adjustments have been applied).
Because lenders require mortgage insurance (MI) for a loan that does not have 20% down payment, the 97% loan must include mortgage insurance (which was an additional $170) in the mortgage payment.
For our example below, we will consolidate some of the assumptions for comparison purposes (e.g., utilities and homeowners insurance would apply across all scenarios so they are not included in this analysis).
Scenario 1 (home value decrease, Denver, Colorado):
Buy before the global financial crisis, in the second quarter of 2006, and then sell during the global financial crisis, in the second quarter of 2011, as compared to renting for five years during the same time period.
Figure 1 shows the starting home sales price of $300,000 and the estimated costs and fees for both the traditional mortgage (with 3% down) and the shared-equity mortgage. The costs associated with the path for renting is shown for comparison.
After five years, the property value/sales price has declined to $246,000 (for more on this, see the section below regarding Milliman’s M-PIRe Platform and the home price appreciation for Denver, Colo.).
The shared-equity lender must cover 52.5% of the loss on the sale. This helped the shared-equity borrower’s financial position. After repaying the principal balance of the loan and the repayment of the down payment to the shared-equity lender, the borrower was able to net $10,571 on the sale of the home.
Overall, when you factor in monthly payments, property taxes and maintenance, and closing and other fees, we see that the traditional mortgage expenses totaled $192,945. Meanwhile, the shared-equity expenses were about $4,300 lower, at $188,612.
Ultimately, in this scenario, the renter paid less than the homeowner to live in the dwelling for five years due to the sharp drop in value of the property by the end of year five. Unfortunately, the timing of the purchase in 2006 and sale in 2011 (just after the global financial crisis, when property values declined substantially) resulted in the homeowner losing money.
In this scenario, the homeowner lost less money with the shared-equity mortgage than that person would have with the 97% mortgage due to the shared-loss component, as well as to the lower mortgage payments over the five-year period. There may be a consideration for the tax benefit to the homeowner in both mortgage scenarios, if applicable.
The Impact of Time on the Mortgage Scenarios
If the borrower remained in that home for 10 years instead of five years and the property value was $246,000, in each scenario the borrower would have paid twice the mortgage payments shown, which would have increased that person’s proceeds at the time of property sale purely due to reduced principal.
However, looking at the details more closely, we see that the cost of the 97% mortgage on a monthly basis and over the 10-year term is higher than the shared-equity borrower’s mortgage. Over the 10-year term, interest expense for the 97% mortgage was $121,618, compared to $98,140 for the shared-equity mortgage.
Due to the larger down payment of the shared-equity mortgage, the loan amount was lower, leading to a lower monthly mortgage payment and overall interest expense. The shared-equity borrower had the opportunity to invest those extra available funds elsewhere or use them for household expenses. It is important to understand all aspects of the costs associated with financing mortgages with varying mortgage products.
Now let’s look at another scenario that occurred in Denver, where our borrower purchased the property after the financial crisis and was able to sell the home five years later at a higher price. For this scenario we again utilized actual home price data from Milliman’s M-PIRe data analytics platform.
Scenario 2 (home value increase, Denver, Colorado):
Buy after the global financial crisis, in the second quarter of 2013, and then sell five years later, in the second quarter of 2018, when the housing market is up, as compared to renting for five years during the same time period.
Figure 2: Buying vs. Renting When Housing Market Is Up
In this scenario, the home property value increased from $300,000 to $528,000 by the end of the five-year period. After repaying the principal balance, all of the upside netted for the sale of the property was retained by the traditional mortgage borrower. The net sale proceeds combined with the cost of the asset over five years allowed a net gain of $89,055.
For our borrower who used a shared-equity mortgage, even though that person had lower mortgage payments and the five-year costs were less, the upside gain of the home appreciation had to be split (the shared-equity mortgage terms specified 47.5% of the gain to the borrower and 52.5% to the shared-equity lender). Therefore, after the sale of the home, $119,700 would have to be paid to the shared-equity lender along with the repayment of the original $45,000 down payment. The net sale proceeds under the shared-equity mortgage combined with the cost of the asset over five years was -$54,660.
In Scenario 2 the traditional mortgage borrower came out ahead. Compared with the shared-equity mortgage, this 97% traditional mortgage option results in $143,715 more proceeds (-$54,660 – $89,055) at the end of the five-year period. That said, both the shared-equity mortgage and the 97% traditional mortgage option are still better options than renting in terms of cash outlay.
Owning the asset longer allows more time for increased principal pay-down for all mortgage types. It also allows more time for home prices to increase (or decrease). The benefits of the shared-equity mortgage include lower interest costs due to a lower interest rate and lower mortgage amount than the traditional mortgage over the life of the loan. In a scenario where property values have worsened, the shared-equity borrower will lose less than a traditional borrower. However, there is a cost associated with sharing in the upside in a sharply improving market.
Just like most things in life, “timing is everything.” The lesson for consumers is that having the proper tools to evaluate the best options for their homes can be quite valuable. Understanding home price trends and using predictive analytics for assessment of future home prices is critical to shared-equity lenders and real estate investors, as well as home buyers.
About Milliman’s M-PIRe Platform
The chart below provides a graph of actual house price movements for Denver, Colorado, from 2002 to the second quarter of 2018. We see that this market is starting to level-off and trend downward.
M-PIRe is a Web-based advanced analytics platform that enables the user to analyze and review current and potential future exposures in the mortgage insurance and credit risk transfer markets, as well as monitor mortgage market trends. The platform offers a holistic approach with integrated data, models, and cash flows and leverages artificial intelligence (AI) to model forward commitment business, ensuring sound investment decision making.
Using back-testing from Milliman’s predictive model, the chart below shows the number of geographic areas with greater than 5% probability of home price declines from the first quarter of 2005 through the second quarter of 2018. This information is valuable for real estate investors, as well as home buyers as they make their rent versus buy decisions.
A shared-equity lender or investor needs to have a perspective on market changes to manage this risk. Using M-PIRe, one can identify the markets with the highest appreciation potential or best locations for shared-equity mortgages over the next two years.
Madeline Johnson, CMB is an executive financial consultant at Milliman Inc. She is a consultant in the Milwaukee Mortgage practice of Milliman and specializes in mortgage finance; capital markets and risk management. She has held senior roles at mortgage insurance and mortgage banking companies as well as consulting for the GSEs.
This paper is for informational purposes only and is not intended to convey any type of advice; legal advice, investment advice or tax advice.