Introduction
First time homebuyers are craving better financial models to collectively purchase shared homes or small plexes, especially in markets where home prices are once again climbing. Although FHA, Freddie Mae and Fannie Mae do a great job of supporting initial purchases by small groups of buyers, none of them can accommodate any shifting in the original borrower group over time. This limitation, unfortunately, causes many groups to abandon the idea of teaming up to purchase homes in the first place. The same limitation also forces the (expensive) refinancing or sale of many homes owned by traditional households following divorce or the death of a family member.
One solution would be to allow “Partial Assumption” of standard mortgage loans. This would let one of the borrowers on a loan assign all of his/her obligations to a new borrower of equal or stronger financial capacity – without changing any other terms of the loan. Accompanying fees would cover underwriting and processing costs, but should be significantly less than the cost of a full refinance.
Can “Partial Assumption” become a standard feature of mortgage loans? I haven’t yet uncovered a reason why not. In the mean time, here’s some background on the underlying issue and some attempts (mostly limited or unsuccessful) thus far at solving it.
It happens a lot
A group of friends buys a house or small plex together. Everyone contributes towards the downpayment, signs for the loan, and pools funds to make the monthly mortgage payments. Eventually, someone moves out and a new person moves in, who takes on a portion of the mortgage (either as rent to the exiting member or as part of the resident group’s pooled funds). Turnover like this might happen a couple more times. Eventually one of the original residents/borrowers who’s moved out decides he or she would like to buy their own home. But to do so, they need out of their commitments under the shared mortgage. To achieve this, those who remain have to either sell or refinance the property. If they sell, remaining group members must disband. If they refinance, they’re faced with all the costs of a new loan and a new (potentially higher) interest rate. Either way, it’s going to be a tough and expensive transition for all involved.
More significantly, the prospect of this course of events dissuades countless folks from buying homes or plexes together in the first place, even though doing so would be an affordable, socially appealing, stable, and tax-beneficial alternative to renting. As young people continue to seek ownership opportunities in cities where single family home prices exceed what they can hope to afford, demand for shared ownership models that really work will only increase.
Is there a less disruptive or expensive way to handle inevitable turnover in small shared housing arrangements? If such a legal structure and/or loan product existed, it would also be beneficial in other instances where household configurations evolve over time (ie. through divorce, death of a family member…). Here are some possible approaches.
Alternative borrowing entities
One idea that’s been tried is to form a limited liability company (LLC) to own the property and be the legal borrower. Residents are LLC members and pitch in rent to the LLC, which in turn makes the mortgage payment. When someone moves out, they can sell their ownership stake in the LLC to a new resident (presumably for something like their portion of the downpayment), and the new resident takes over the monthly rent obligation.
Unfortunately, this approach fails to solve the core problem. Although the members of the borrowing LLC can turn over, the mortgage lender will have required personal guarantees of the LLC from the original group of residents. This lender requirement makes a lot of sense, since the LLC just sprung into existence and has no track record of its own to be a deemed a reliable borrower. Original guarantors don’t get off the hook to the lender by exiting the LLC, so they remain entangled with the property, limiting their ability to obtain financing elsewhere.
Two other downsides of this model are: (1) lenders charge higher interest rates on loans to LLCs than they do to owner-occupant borrowers, and (2) it’s complicated or impossible to pass through the mortgage interest deduction to residents with this structure.
I should note that the problems with the LLC-as-borrower approach, described above, also apply to other borrower entity types (ie. cooperative or non-profit corporation).
Condominium conversion
Converting a small plex into separate pieces of real property through the condominium conversion process solves the turnover problem by allowing each unit owner to obtain mortgage financing just for their unit. Residents can sell units independently from one another and purchasers can obtain their own, independent financing.
Condo conversions aren’t easy or cheap, since they require professional services of attorneys, surveyors, reserve analysis experts… which can cost $20K+. They work for converting plexes to self-contained units, but not for shared ownership of larger homes (Actually, such homes could technically be divided into condos. But I doubt a lender would be comfortable relying on a portion of a group house as collateral for a mortgage loan). Finally, some jurisdictions place restrictions on conversions. Examples include San Francisco’s strict lottery and multiple cities’ requirements to bring buildings up to current codes as a condition of conversion.
Fractional ownership
In San Francisco, it’s increasingly common for two or more people to purchase small, multi-unit buildings as Tenants In Common (TIC). This is a form of fractional ownership, and financing is available either as a group TIC loan secured by the entire property or as separate Fractional TIC loans secured solely by each party’s fractional interest in the property (and accompanying right to occupy one of the units). Here’s a nice summary of how these loan products work.
Fractional TIC loans solve the fundamental turnover problem described above. However, they are only availability in a few markets (San Francisco, CA, others?), where there is deep enough demand and enough comps to get lenders interested and comfortable. Fees are higher than for typical owner-occupied loans; only a few lenders make these loans; and fixed terms don’t extend beyond 7-year ARMs.
Partial Assumption
A traditional 1-4 unit mortgage lender could charge a ‘partial assumption’ fee for an exiting borrower to assign all of his/her obligations under the loan to a new ‘replacement’ borrower. The new borrower would presumably need to be at least as strong, financially, as the one being replaced. The lender’s fee would cover underwriting of the ‘replacement’ borrower, processing of requisite paperwork, and overhead & profit. All the loan terms (ie. interest rate, term…) could remain unchanged.
This approach would work both for single family homes and 2-4 unit plexes. Logically, the partial assumption fee should be significantly lower than the cost of a full loan refinancing because there would be no need to re-evaluate the value of the property (ie. appraisal), assess the financial strength of the remaining borrower(s), or create and document an entirely new loan. Finally, this should be appealing to lenders because the collective borrower strength would be equal to or greater than what it was prior to the partial assignment.
If there’s a good reason this approach couldn’t work, I haven’t found it yet. So for now, I’m interested in digging in a bit deeper. First step: check in with FHA, which already offers assumable mortgage loans, to see if they’d consider offering something like this.