A growing equity mortgage is a type of fixed-rate mortgage. These mortgages are designed to help people who want to build equity in their homes quickly—this type of mortgage benefits young applicants or first-time home buyers who can’t afford high initial payments. There are a few advantages and disadvantages to this type of mortgage, which the buyer must know before obtaining it. In this post, I’ll explain growing equity mortgages with the help of examples.
What is a Growing Equity Mortgage?
A growing equity mortgage is a mortgage in which the interest rate remains the same throughout the term, but the payments increase yearly. The payments increase to include more principal according to the previously agreed-upon payment schedule. The increased amount of principal shortens the loan term and helps increase the equity in the home faster as compared to a conventional loan. This allows home buyers to get full ownership of the house sooner, as the mortgage is paid off quickly. The term for a growing equity mortgage is almost half as compared that of a conventional mortgage.
At the start of the term, the buyer is required to make regular payments, and then the annual payment increases. With fixed-rate mortgages, the interest rate is fixed, and the regular payments are fixed too. However, with GEM, only the interest rate is fixed, and the payments increase yearly during the term. There is no negative amortization on these loans, and the interest rate remains the same throughout the term. Negative amortization occurs when the loan payment is less than the interest for that period, which increases the outstanding loan balance.
Equity is the difference between the price of your home and the outstanding mortgage balance. It can be calculated anytime during the loan term by subtracting the mortgage balance from your home’s market value. The current value of a home can be estimated at Realtor.com or talk to a realtor or real estate agent. Besides that, the mortgage balance is present on the loan statement that the lender can provide. The following is the formula to calculate home equity:
Home equity = Home value – Mortgage principal balance
For instance, if the home value is $300,000 and the mortgage principal balance is $170,000, the borrower will have $130,000 of equity in the home. If you are willing to get a Home Equity Line of Credit, it is better to know how much equity you have because it will determine the funds you’ll have at your hand when you get a HELOC.
How do Growing Equity Mortgages Work?
Growing-Equity Mortgages have predetermined fixed interest rates for the whole term, and payments rise gradually. The GEMs have a repayment period of 15 to 20 years, and the rise in payments is around 5% per year. During the initial years, payment is low and calculated similarly to a 30-year mortgage. After the initial years, the payments rise yearly, and the extra amount is added to the principal. As the borrower pays down the principal, they build equity in their home faster, which also decreases the loan term.
The rise in payments is between 1% and 5%; the percentage of rise is set during the loan agreement. The borrower agrees to a fixed-rate mortgage in the loan agreement, and the first payment is fully amortized. When the payment increases, the extra amount above the fully amortized payment is applied to the outstanding mortgage balance. The increase in payments occur gradually, and the percentage increase is based on an index, such as the Commerce Department Index. One thing to note is that since GEM has increased payments annually, the borrower’s salary should also accommodate the increasing principal.
Benefits of Growing Equity in Home
The equity changes throughout the term as the payments increase. When the homebuyer builds equity in the home, it becomes a source of wealth that they can use for meeting financial expenses. The following are the main benefits of building equity in the home:
Low Down Payment
Growing equity mortgages have low down payment requirements, which make these mortgages very affordable. This is helpful for moderate-income buyers as they don’t have enough savings to make huge down payments. For example, FHA offers growing equity mortgages that require a down payment of only 3.5%.
Growing-Equity mortgages offered by FHA have flexible eligibility requirements. If the borrower has a low credit score and can’t qualify for any other mortgage, they can consider applying for a growing equity mortgage, but only if they have built equity in their home. To qualify for a GEM, the borrower should have a credit score of 620 or higher and a debt-to-income ratio of 43% or less.
The borrower can benefit from the equity in the home by paying off high-interest debt. For instance, debt consolidation loans, personal loans, and credit cards have higher interest rates. On the other hand, home equity loans have lower interest rates; consolidating with this loan can help save a lot in interest payments.
Homeowners can borrow funds against the equity in their homes and use that amount for almost any purpose. A home equity loan is the best option if the borrower wants to have a lump sum to meet a large expense. On the other hand, if the borrower wants a monthly loan income, a home equity line of credit or HELOC is suitable. The borrower can also withdraw cash when they need it. They can use this amount for home improvements and add more value to their homes.
No Negative Amortization
There is no negative amortization with the Growing equity mortgages. Negative amortization occurs when the monthly payments are so low that they can’t cover the interest. This means that the interest rates are high. With GEMs, the interest payment remains the same, and there is full amortization of the loan.
Faster Accumulation of Equity
With Growing equity mortgages, the home buyer saves money on the interest in the long run. Besides that, they also help build equity faster. The additional amount the home buyer pays goes to the principal and reduces the outstanding balance on the mortgage. This means the borrower quickly takes a large share of the equity by making big payments. This also allows the homeowner to build long-term wealth.
Profit After Selling Home
Owing a more significant share in the property is always profitable. If the borrower has greater equity in the home, they can have more profit in the sale. Most borrowers can sell the property at a price more than they owe on that property, allowing them to pay the outstanding mortgage and keep the profit. Even if the market is down if the borrower has more than 50% equity in the home, the proceeds from the sale will result in a profit. The borrower can use the profit to purchase another affordable home or pay off the current debt.
Growing-Equity Mortgage Examples
Example 1: Suppose Tim has a home appraised value of $225,000. He has an outstanding mortgage of $115,000. Tim wants to know his home equity so he can borrow against his equity. He calculates his equity in the following ways:
- Home Equity: $225,000 – $95,000
- Home Equity: $130,000
This shows that Tim has equity of $110,000 in the home, and he can borrow against this amount to get funds. Tim cannot pay the outstanding mortgage balance of $95,000, so he decides to sell the home. After selling the home, Tim pays $95,000 to the mortgage lender and keeps the remaining $35,000 as profit. This shows how building equity in the home can benefit the homeowner.
Example 2: Suppose Jane purchased a home worth $200,000 at 5% with a Growing Equity Mortgage. Since it’s a growing equity mortgage, the interest rate will be fixed throughout the loan term. She also paid 10% as a down payment, and now she has a $180,000 mortgage balance which she has to repay during the loan term. During the initial years, Jane had to pay $1,781.76 every month, which makes an annual payment of $20,281.14. After five years, the yearly payment increases by 5%, and Jane has to pay $21,295, which is not too much. The total loan at the end of the term costs her $309,317, and she builds full home equity.
Now, if Jane had obtained a conventional loan to purchase a home worth $200,000 at a 5% interest rate for 30 years, the loan would have cost $455,710.41 at the end of the term. This example is showing how growing equity mortgages are cheaper regarding the total cost of the loan and allow the homebuyer to build equity faster.
Frequently Asked Questions
What are the Alternatives to Growing Equity Mortgages?
The alternatives to growing equity mortgages include conventional mortgages and FHA loans. With a traditional mortgage, the interest and payments are fixed for some time. Most conventional mortgages are 15, 20, or 30 years. If the borrower wants to build equity in the home, they can also choose traditional mortgages with shorter terms, for instance, 10 or 15 years. This will help the borrowers pay off their debt quickly and build home equity.
Conventional mortgages are a good alternative to growing equity mortgages, but they are not easy to qualify for. If the borrower is looking for mortgages that are easy to qualify for, they can consider FHA loans. These loans have flexible requirements and are available with a very low down payment requirement. Besides, these loans have no prepayment penalties, allowing the borrowers to pay off the debt without additional fees.
How can a Borrower Build Equity in Their Home Faster?
There are various ways through which the borrower can build equity in their home. The main idea is to decrease the mortgage balance or increase the property value so that the homeowner’s share in the equity increases. The borrower can build equity in the following ways:
- Make a big down payment
- Increase the property value through home improvements
- Pay more on the mortgage
- Refinance to get a shorter-term loan
- Wait for the property value to increase
Building equity is a slow process, but once the homeowner has built enough, they can borrow against their equity using home equity loans or HELOC. Making home improvements can boost the property’s value and allow the residents to live a better lifestyle. Besides, if the borrower has enough money to pay down, it will help reduce the mortgage balance. The more the homebuyer pays off the mortgage balance, the greater their share will be in the equity.
What is a FHA Growing Equity Mortgage?
FHA growing equity mortgages are mortgages backed by the government. The FHA issues these mortgages according to the FHA section 245(a), which allows the borrowers to purchase homes. These mortgages are intended for borrowers with limited income but expect a rise in their income in the future. FHA GEMs start with low payments that gradually increase over time.
What to Know for the Real Estate Exam
A growing equity mortgage is a useful tool for building equity in the home. The mortgage is suitable for first-time home buyers or those with low to moderate income. These mortgages have low initial payments for a few years, and then the payments increase annually so that the borrower builds equity in the home faster. The interest rates are fixed; only the payments increase, which adds to the principal amount of the mortgage, and thus the borrower’s equity increases. Having greater equity in the home in a shorter period is very beneficial, as it helps build long-term wealth and allows the homeowner to borrow more against their equity. If you want to master your real estate exam, read more about such real estate definitions.