Most families will go above and beyond the call of duty to help each other out. But have you ever heard of a relative selling a home to another relative with no down payment? It happens; it happens all the time. The down payment comes in the form of a gift of equity, and it can be extremely beneficial to the buyer on a conventional loan.
Understanding the Gift of Equity
When a buyer owns a home that is worth a lot more than the mortgage balance, the difference is called equity. In the case of an retired person who has paid on a home since the Johnson administration, they may have only a few years left on their mortgage, thus they have a lot of equity on their home.
Example: if someone purchased a house 22 years ago with a 30-year mortgage, they would have only 8 years left on their home loan. If the home is currently worth $250,000 but the balance on the existing loan is only $62,000, then that would mean the owner has approximately $188,000 in equity. Not too shabby, eh?
But here’s where the gift of equity comes in: instead of asking a home buyer to come up with a 20% down payment, the owner could gift 20% of the home’s value to the buyer. This would allow the buyer to apply for a loan that is only 80% of the home’s value.
Here’s a hypothetical example:
John is 28-years-old and would like to buy a home. His parents have been paying on their home for 22 years. The balance of their mortgage is currently $62,000. The home is valued at $250,000. The parents would like to downsize and sell their home to John.
The parents offer to sell the home to John for $250,000. However, they also offer a gift of equity of $50,000. Therefore, John will need to contact his mortgage lender and apply for a loan of $200,000. This would allow his parents to receive a profit of $138,000 after giving away the equity to their dear, beloved son and paying off the old mortgage.
Saves the Borrower from PMI
One of the best advantages of the gift of equity is avoiding private mortgage insurance (PMI). Since a conventional loan charges PMI any time the borrower gets a mortgage over 80% of the home’s value, the gift of equity avoids this charge. Over the course of the loan, the lack of PMI could save the buyer thousands and thousands of dollars.
Who Pays Closing Costs?
As with any conventional mortgage, there will be closing costs involved. The home appraisal, recording the deed at the local county registrar’s office, property taxes, and several other items will all need to be paid at the closing attorney’s office when the deal is closed. For a conventional loan, guidelines state that the seller may pay up to 3% of the sales price in concessions towards closing costs.
Going back to our example of John and his parents, this would mean the parents could provide $7,500 towards the closing costs, reducing the amount of profit they receive from the transaction, but still allow them to assist John with the purchase of the property.
Potential Tax Issues
Warning: if you have a phobia of the IRS (and who doesn’t?), a gift of equity may result in some tax issues. The Feds put a limit on the amount of cash or equity that a person can give to another. For example, for the year 2019, the maximum amount of money or equity that can be given to a person is $15,000. Any amount that exceeds this limit will result in the giver of the gift being required to fill out certain forms with their annual tax return. It is best to consult with a local accountant that is familiar with gift and estate taxes in order to get the correct answer about tax consequences with a gift of equity.
True Value of the Home
Your prospective home will need to be appraised by an independent rep in order to determine the home’s actual value. For instance, in the above example, if the parents were trying to sell the home for $250,000 but the appraiser calculated the home’s worth at only $190,000, then the lender would not allow the transaction to go through. The sales price would have to be lowered along with the size of the equity gift.
Only Allowed with Family Members
According to conventional loan guidelines, there are some restrictions on the gift of equity transaction. Specifically, the seller of the home must be directly related to the buyer. The lender will want to see a transaction between a parent and child, or a grandparent and grandchild or an Aunt/Uncle to a nephew or niece. It is not common for a 6th cousin twice removed on the mother’s side to sell to a distant relative.
Documenting the Gift of Equity
Lenders may want to see a letter from the giver to the recipient. In a nutshell, the letter will need to describe the relationship between the two people, the amount of the gift of equity along with a statement that this is truly a gift and there is no expectation that the amount will be repaid. Your local lender can provide a template of the letter for you to use in order to satisfy this requirement.
Summing Up Gift of Equity Conventional Loan
Completing a gift of equity transaction will take planning and negotiation between both sides, but at the end of the day, it can be a huge benefit to the buyer. This is one of the few ways of buying a home without the need for a large cash payment, and without having to purchase private mortgage insurance. It is also a commendable way for a person to significantly help out one of their relatives without giving them a huge chunk of cash, while still taking advantage of the equity in their home.
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