An Equity Question?

A borrower's equity in a given deal is a good indication that the loan is relatively secure and more so on a new loan. Equity in this context, presents two closely related nuances- the borrower's vested economic interest in the deal (a risk of loss)and, the “cushion” offered by the liquidation value of the collateral. Lenders refer to this cushion as “protective equity”. The minimum equity considered sufficient to mitigate the low equity risk factor, ranges from 20% of the purchase price for owner occupied residential property to 25%-30% for prime commercial loans and up to 35%-50% for higher risk “special use” properties, businesses, and various types of land deals. The problem is, most buyers don't usually have the cash available to make these kinds of down payments.

People tend to think of down payment equity as represented by the amount of cash the buyer puts into the deal. Fortunately, equity can come in many forms such as cars, antiques/collectibles, boats, fine jewelry, stock portfolios, time shares, other properties, even other notes. This might be viewed as a form of bartering, and it occurs quite frequently, particularly in real estate exchanges. For astute deal-smiths, creating equity can take can take on several other practical forms as well. Substituted collateral is one such effective technique.

A good illustration is your client is asking $125,000 for his home. He has an existing 1st mortgage of $90,000 dollars. He gets an offer of $6,500 cash down, and a owner financed second mortgage for $28,500. Both you and your client are concerned about the limited down payment, especially when being asked to carry back a 2nd position junior real estate note. However, the buyer owns a duplex he exchanged two years ago. The value of the duplex is $140,000, with an existing first mortgage of $90,000 owed against it. Instead of securing the 2nd note by the seller's residence, the buyer offers his $50,000 equity in the duplex, as substitute collateral to secure the real estate note.

Going this route, your client picks up the difference between the Combined-Loan-To-Value he would have carrying the note back against the property he is selling ( $90,000 + $28,500/$125,000 = 95%), as opposed to the lower CLTV he would achieve by accepting the substituted duplex collateral for the real estate note ($90,000 + $28,500/$140,000=85%). The use of substituted collateral in this instance has increased the buyer's equity in the deal by 10% more. Bookmark this blog now, and come back for the rest of this story in my next blog. For more information now on this subject contact me.