The Mortgage Professor: Unmarried couples buying a house may also be buying trouble
More and more couples, both mixed- and same-sex, are electing to live together without getting married, and often this includes purchasing a home together. This is a major decision fraught with potential consequences if and when they decide to split.
SET GROUND RULES FOR A SPLIT BEFORE A PURCHASE
Couples who have just decided to live together are understandably reluctant to discuss how they will want to deal with a split when it comes. Facing the issue at the outset, however, may save a ton of expense, aggravation and acrimony down the road. They should consider, furthermore, that a failure to agree on the ground rules that will govern a split might well indicate that the relationship will probably not last very long. This may prompt them to reconsider their decision to purchase the home together.
SIMPLEST RULE: SPLIT MEANS SALE
A pre-purchase agreement that the house must be sold if either partner aborts the relationship avoids some thorny issues that can arise when one partner stays with the house. The only issue in this case is how the proceeds are to be divided. Equal shares may not be equitable, depending on the respective contributions of each partner.
One approach is to divide the net proceeds by each partner’s contribution to the equity in the house when it is sold. Suppose, for example, that the partners pay $100,000 for a house, take a mortgage of $80,000, pay $20,000 down plus $3,000 in settlement costs, and sell it after 5 years when the loan balance is $74,000. Total contributions of the partners to equity in the house at the time of sale consist of $23,000 in cash at purchase, plus $6,000 in reducing the loan balance. If one partner contributed 60 percent of the cash and paid 40 percent of the expenses, that partner’s share of net proceeds would be 56 percent.
In some cases, this rule would not be fair. For example, one of the partners might unilaterally work on improving the house, which would call for a higher share. The point is that the partners ought to agree on the general formula at the outset.
COMPLEXITIES MOUNT WHEN ONE PARTNER STAYS IN THE HOUSE
—Valuing the property: When one of the partners remains in the house, the terms of settlement are more complex. There is no sale price, so the partners must agree on an appraisal procedure and on who will pay for it. They should also agree on whether a real estate sales commission should be deducted from the valuation used in the settlement. If they wait until the event, this is invariably contentious.
—Paying off the departing partner: Another problem arises if the partner remaining in the house doesn’t have the money to pay off the partner who is leaving. The more equity they have in the house, the more cash the resident partner needs to raise. A home equity loan is not possible unless both partners become responsible, which is the last thing the departing partner wants.
—Taking the departing partner off the hook: Much the largest problem, however, is the departing partner’s continuing responsibility for the mortgage. Many departing partners believe that they are off the hook because the partner remaining in the house has agreed to assume full responsibility for the mortgage. They (and evidently their lawyers) overlook the fact that the lender was not a partner to their agreement. Departing partners who remain liable for their mortgages often are unable to get new mortgages on their own.
Lenders have no incentive to remove one partner from the note. Some can be induced to do it if the partner remaining with the house has a perfect payment record and can document that they have been solely responsible for the payments for some considerable period — perhaps a year. But if the lender refuses, the only way to get the departing partner off the note is for the remaining partner to refinance in her own name.
—Which partner takes responsibility: If I were drafting an agreement for a loved one, not knowing who was more likely to be the remaining or the departing partner, it would grant the remaining partner 14 months to make the settlement payment, and to get the departing partner removed from the note. Otherwise, the house must be sold and the mortgage paid off.
—Implications of a declining market: If the house is worth less than the mortgage balance when the couple split, which is likely if they purchased at the peak of the market in 2006, the options are grim. The house can’t be sold unless the partners pay the deficiency. If neither partner wants to remain in the house and the amount required is small enough to be manageable, that may be the best option. The alternative is foreclosure, which will destroy the credit of both partners.
If one partner wants to stay in the house and continue to make the payments, the partner that leaves avoids foreclosure but will remain liable indefinitely. It may take years before the partner that remains is able to refinance in his or her own name.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.