Why this article is important: Home equity investments (HEIs) are returning, gaining traction against other types of equity participation financial products. But the risks involved are immense and complex.
Your home, your ATM
So, your client wants access to the equity in their home. Maybe they want to perform major improvements on their home. Maybe they want to consolidate debt. Or maybe they are retiring and need access to additional income. The temptation to use their home asset as an ATM is real.
A reverse mortgage is classified as an open-end line of credit secured by a lien on the borrower’s family dwelling. Reverse mortgages — also called home equity lines of credit (HECMs) — are complex, atypical financial arrangements. As such, borrowers frequently do not understand their terms, much less their financial consequences.
Another similar product, the home equity line of credit (HELOC), allows homeowners to draw on their home’s equity. The main differences are that:
- HELOCs may be originated by homeowners of any age, and require monthly payments; and
- HECMs may be originated by homeowners who are 62 years of age or older, and no payment is due until the homeowner vacates the property, dies or sells the secured property.
Now, another option exists for the homeowner with poor credit, low income or other disqualifying debt aspects: the home equity investment (HEI) mortgage. This home-ATM device takes the complexity a step further, as highlighted in a recent advisory from the Department of Financial Protection and Innovation (DFPI).
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Even riskier HEIs as equity sharing
A typical home equity sharing HEI requires the homeowner repay the mortgage as a lump sum — a balloon payment — on a due date, which can be 10 to 30 years after origination, but is due on any earlier sale of the home.
But just how much the homeowner will pay to satisfy the equity sharing arrangement is unknown when the homeowner signs the agreement. The amount due for the final ballon payment is based on the home’s future value, on the due date.
Readers may be familiar with a similar arrangement, made popular in the 1980s, called equity sharing, in which an investor acts as a lender and receives two types of earnings on the money lent:
- interest payments; plus
- equity sharing in the property’s appreciation — profits — set as a percentage of net equity increase in value of the secured property after originating the mortgage. [See RPI Form 430]
Another similar arrangement is equity sharing co-ownership, which is not a loan. The arrangement grants co-ownership of the property to an additional title holder (or instead an LLC), contingent on the co-owner as an investor providing down payment money for purchase of the property. Watch for agents creating deals for first-time homebuyers using this arrangement. [See RPI Form 154-1]
Historically, the appreciation participation (AP) mortgage entered real estate vocabulary in the 1960s, when interest rates were rising rapidly, somewhat like rates experienced since 2021. This involved real estate investors willing to buy down the interest rate on a mortgage in exchange for a portion of the appreciated value when the homebuyer later sold the secured property.
Today, much like those who take out HECMs and HELOCs, homeowners report taking out HEIs to pay off other debts and make home improvements. Further, over 90% of HEI borrowers still owe money on a first lien mortgage when they take out an HEI, according to the Consumer Financial Protection Bureau (CFPB).
In other words, between their first lien and the HEI, the homeowner taking out an HEI may very well be underwater when principal becomes due and a recession occurs in the interim. Then, their only options are to liquidate other assets to pay off the HEI, or default and force the lienholder to foreclose.
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The unpredictability of HEIs
In an example provided by the CFPB, consider a homeowner taking out an HEI today for $50,000. Their mortgage documents specify the amount the homeowner is to pay the lienholder on the mortgage due date, which is:
- the amount of the money lent by the lender; and
- the amount due the lender as their earnings from their share of home appreciation since originating the HEI.
For example, in the unlikely event a home depreciates in value on average of 1% a year for 15 years, the homeowner may owe as little as $52,000 (an improbable, though fair deal for the homeowner). However, when the home appreciates in value on average of 3.5% annually over 15 years — California’s long-term, reliable appreciation rate — the homeowner may owe the HEI lienholder as much as $235,700.
This unpredictability in settlement amounts means a homeowner who takes out an HEI is gambling with their biggest investment and asset: their principal residence sheltering the household.
Other downsides include:
- the lienholder’s ability to call the loan due when the homeowner doesn’t maintain the property to the lender’s standards, limited by California rules regarding waste; and
- the restriction found in most HEI security agreements (trust deeds) limiting the homeowner’s ability to move and rent out their residence without triggering the due on sale provisions in the mortgage for calling the loan due, as permitted by federal mortgage law.
Still, the advertisements for HEIs include promises of zero interest, no monthly payments, and even no income requirements. Attractive promises, for some.
Worse, unlike traditional HECMs, which are highly regulated, HEIs are still operating in the jurisdiction of the Wild West, where the rules are made up by the biggest players running the game — the fintech companies who originate these “investment opportunities” for sale to investors. These are actually loans secured by the property, not a co-ownership of title.
Governance over HEIs
Unlike traditional HECMs, HELOCs or even cash-out refinances (which accomplish similar goals), HEIs presently fly below the radar when it comes to federal regulations governing mortgage financing.
The reason? HEIs are contractually structured as equity-sharing agreements and not as debt instruments. If they are not mortgage debts, (which they are), rules like the Truth in Lending Act (TILA) do not apply. California law recharacterizes contact lending as a mortgage obligation as no ownership rights and obligations apply to the lender.
Editor’s note — At the time of this writing, a federal bill is under consideration which seeks to amend TILA to include HEIs as debts, not co-ownership interests.
Worse — the company originating the HEI may structure their contract to specify the HEI is a recourse loan, meaning an underwater homeowner may end up owing the company money even after a foreclosure.
In contrast, California’s anti-deficiency protections for nonrecourse mortgages — mortgages funding an acquisition by a homebuyer-occupant — limit the collection of any underpaid amount to the value of the property at the time of payoff (foreclosure sale). [California Code of Civil Procedure §580b(a)]
As such, the typical mortgage loan originator (MLO) or traditional mortgage lender will not originate an HEI. This is left to shady fintech companies and ill-informed private money lenders.
Clients seeking to tap the equity in their homes need advice from their buyer agent to stay away from this dangerous product. Any homeowner borrowing money secured by a trust deed lien on title to their principal residence needs to understand the risks involved — an impossibility for HEIs.
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