There’s an old saying that they don’t ring a bell at the top of the market.
But I swear, sometimes they really do.
I was in Baltimore this past week catching up with my colleagues. We were talking about the frothiness in the housing market, and someone mentioned they’d stumbled across “co-investing.”
Apparently, the housing market has been so hot lately that investors are now lining up for a piece of your house.
Home equity loans have been around forever, of course, and are almost always a terrible idea. But this is something new and different. In a traditional home equity loan, you borrow money using your house as collateral and make regular payments. Your house can rise in value or fall in value, but it doesn’t affect the amount you owe. It’s really nothing more than a second mortgage.
This Is Not Normal
That’s not at all what happens in a co-investing mortgage. In these schemes, an investor fronts you money today in exchange for taking a piece of your home’s equity that you in turn agree to buy back at the end of the term. But the catch is that you have to pay it back based on the market value at the end of the term.
You see a problem here?
My house in Dallas has appreciated by around 50% since I bought it in late 2011. But in plenty of markets, homes have more than doubled. If I had been stupid enough to sign away a large chunk of my future appreciation, I would walk away from a future sale with a lot less equity.
I went to the website of a large co-investor to play with the numbers. This particular vulture… oh sorry, “investor,” takes a 40% share of future appreciation in exchange for a 10% equity interest.
As a hypothetical, let’s say your home was worth $400,000 and you borrowed $40,000 to spend on a trip to Las Vegas. (Because, let’s face it, if you’re irresponsible enough to make a co-investment deal, blowing $40,000 on casinos, cocaine and call girls wouldn’t be out of character.)
After a few years, your house has risen in value to $600,000. Well, you still owe the $40,000 you borrowed. That hasn’t gone away. But the co-investor is also entitled to $80,000 of your home equity. You now owe $120,000 on a loan you made for $40,000.
It’s bad enough if you sell the house. You’d be walking away with a lot less money to put towards your next one.
But what if you don’t plan to sell the house?
Well, you still owe the money. So, at that point you either have to take out another loan to pay back this one or just sell your house.
It’s not just home equity loans, by the way. Co-investors will front you the money to buy your first home, too. But if the investor is pocketing a large share of the capital gains, are you really an owner at that point, or are you really just a glorified renter?
I’m struggling to imagine a situation where a deal like this would make sense. It’s better than going to a mafia loan shark, I suppose, though not by much.
You don’t see deals like these in a normal, healthy market. You see them in bubbly market that’s near the end of the road.
Know What You Shouldn’t Do
I’ll wrap this up with some basic principles for navigating a market like this.
To start, there is no shame in renting. If you can’t afford the house you’re eyeing, consider renting instead. Or consider a cheaper house in a different neighborhood. Taking on a debt you can’t really afford is a recipe for heartburn and some uncomfortable conversations with your family down the road.
Home equity is not a checking account. One of the real benefits of homeownership is eventually owning the property outright and getting to live there for free, at least after your property taxes and insurance. If you continually borrow against your house, you’ll never own it. You’ll just perpetually rent it from the bank.
And finally, keep in mind that emergencies do happen, and your home’s equity could, in a pinch, be a financial lifeline. But you have to be honest with yourself. Are you really facing a short-term emergency? A new pool or kitchen remodeling isn’t an emergency.
If you’re smart, you won’t fritter away your home equity, you’ll add to it by paying down your mortgage faster. If you find yourself with a couple hundred extra dollars lying around, add a little extra to your mortgage payment. It goes straight to principal reduction, and it can shave years off the length of your mortgage