How equity affects a swap and why it’s not always what you expect

I highly recommend letting the lawyers or mortgage professionals handle the details of financing a house swap. So first the disclaimer:

Note: The information contained on this site is not intended to offer legal or financial advice. Please consult a lawyer or financial planner for any legal or financial questions.

And let me state one more time, when we talk about a swap, we are talking about two simultaneous sales, recently termed a "reciprocal sale". Swap is just a better metaphor. I though about naming this site domureciprocalsale.com, but chose not to.

With that said, I was recently posed a question about financing a specific swap. The answer turned out to be not what I expected, but ultimately enlightening.

First, the scenario. A Domuswap user writes:

I can not see on your website how you can swap a property with a mortgage. It seems to me that you would have to re-qualify for a loan on the property you are buying at full price, and the same for the person you are sapping with. I saw an article that said you only had to qualify for the difference, but I can not see how that is possible.

I then asked for the home values and equity positions involved, since we all know that is one of the most important aspects of this transaction. The user, A Realtor/investor, has several properties listed on Domuswap, and has evaluated several proposals on each. The user responds with one scenario:

One instance was a buyer who wanted to trade his $200,000 house (which he had no mortgage and extra cash) for my $243,000 house that is completely mortgaged and has virtually no equity.

Let’s look at the details. We’ll call the user asking the question Sally. We will call the other owner Bill. I’ve found this works better than calling them OwnerA and OwnerB. I guess it personalizes things and differentiates the two parties by more than one letter. Anyway.

Sally has no equity in her property. Immediate red flag. We know that having no equity almost always makes swaps unfeasible. But lets examine this situation further. Sally owes 243K on her property. Bill with buy Sally’s house with 200K of his house plus 43K in cash. Let me add now that this analysis doesn’t factor in taxes, closing costs, commission or other fees. How convenient. Simply double all the costs involved. Just kidding, but you get the picture.

To sell her property, sally must pay the mortgage holder $243K. She has 43K in cash from Bill. She therefore needs to come up with another 200K. If she has 200K in her bank account, she is in luck. But since she has no equity, this is unlikely. The other possibility for cash is from a new mortgage secured to purchase Bill’s property. Bill’s home is appraised at 200K. Using a standard 20% down payment requirement, the most she could mortgage is 160K. Normally, that 160K would go to Bill, the seller, but since Bill is using the property to purchase Sally’s, it can go directly to Sally. That gives Sally 160K + 43K in cash, which is 43K short of what she needs. She will need to come up with another 43K in cash. In some situations, this could be a loan against another property. But again, since she has no equity, this is probably not a possibility. Therefore, equity really matters, and this particular deal is not a possibility.

Let’s make things more interesting. Let’s assume Sally has 50% or so (say 125K) equity in her house. She now owes the bank 118K. 43K of that comes from Bill’s cash payment. That leaves an additional 75K. Now Sally would only need a 75K mortgage on her 200K purchase, which is much more reasonable. Remember, you are more likely to get a mortgage if you have a large equity stake in the property. In Sally’s case, she will have a 125K equity stake in the new house.

Anyone having done a bit of mathematics in the past might be thinking there must be a formula for all this. And they would be right. Here it is:

E=H2*D

Where E=Equity needed in your existing property

H2 = appraised value of the property you are interested in

D = percent down payment required to qualify for a mortgage (typically 20%, or .2)

So for Sally, she would need 200*.2 or 40K in equity for make the deal work.

The interesting thing about the equation is that the value of the owners current home is not a factor, only the equity position in that property.

Let’s verify those numbers, assuming the 40K equity position.

Sally now owes the bank 203K. She receives 43K from Bill in cash. Leaving 160K remaining, which is the assumed maximum mortgage she can obtain.

There you have it.