When buying a home, your down payment can come from several places. Some common sources of down payments include personal savings, a Registered Retirement Savings Plan (RRSP) via the Home Buyers Plan, a settlement from a marital split or a gift from an immediate family member.
What many Canadians may not realize is that a down payment can also come in the form of a gift of equity when a property is being purchased from a close family member. But what exactly is a gift of home equity, and how does it work? In this article, we’ll cover everything you need to know about gifts of equity, including the pros and cons.
What’s Home Equity?
Home equity represents the difference between the value of a home and the amount of any mortgage outstanding. For example, if you own a home that’s worth $300,000 and the balance owing on your mortgage is $150,000, then you’d have $150,000 of home equity in that property. As your mortgage continues to be paid down and/or the value of the home increases, your home equity will also increase.
How Can I Use My Home Equity?
There are a few ways in which home equity can be used by a homeowner. The obvious one is that when you sell your house, you get to keep any remaining equity after the mortgage is paid in full and any associated closing costs are covered. While you’re living in your home, you can borrow against the equity to pay for home renovations, to make a major purchase, or to consolidate higher-interest debt.
Gifts Of Equity Explained
There’s another way in which you can use your home equity, and it happens to be the focus of this article; that is, you can provide a gift of equity if you sell your home to a close family member. Here’s how it works.
Using A Gift Of Equity When Purchasing A Home
There are times a person may decide to purchase a home from a close family member. Often, it’s a child who opts to buy a parent’s home. Perhaps their parents are ready to downsize and selling to a close family member makes sense. It could be for any reason at all.
In these situations, the parent may want to give some, or all, of the equity they’ve built in the home to their child, in the form of a gift. They may do this purely as an act of generosity, or because their child doesn’t have enough money available for the down payment. In these situations, the gift of equity serves as the down payment for the child who’s buying the home.
But it doesn’t have to be a parent selling to their child. It could be the reverse, or even a transaction between other close family members. There are no hard and fast rules, but most lenders limit gifts of equity between close family members.
How A Gift Of Equity Works
To understand exactly how this works, we’ll use the following example:
A couple owns a house valued at $300,000, with a mortgage owing of $200,000. They’ve decided to sell their home to their daughter and her husband, who don’t have enough saved for a down payment. In this situation, the parents have decided to provide a gift of equity of $60,000, which will serve as a 20% down payment.
They draw up a purchase and sale agreement with a purchase price of $300,000, and a down payment of $60,000 in the form of a gift of equity. In doing so, the parents are agreeing to only receive $240,000 for the sale of their home. After their $200,000 mortgage is paid from the new mortgage proceeds, the parents will net $40,000 in their pocket, less if there are any closing costs like lawyer fees.
Their children won’t have to provide a down payment from their own resources, however, they still need to cover all closing costs from their own resources. Closing costs are usually estimated at 1.5% of the purchase price and include lawyer’s fees, as well as any other applicable costs such as an appraisal fee or land transfer taxes. In most cases, the parents will need to sign a gift letter for the lender, stating that the equity is indeed a gift and that there’s no expectation of repayment.
Gifts Of Equity Pros And Cons
There are obvious benefits to receiving a gift of equity. Not only is the buyer not required to cover the down payment, but they’re essentially purchasing the house below market value. There are also benefits for the seller. While they are relinquishing some equity by selling to family members they avoid the hassle of having to list their home on the market as well as the expense of having to pay REALTOR® fees.
On the flipside, gifts of equity won’t always work. It’s reserved for close family members, and even then, the buyer’s lender may not approve the arrangement if the buyer’s credit history isn’t strong. Of course, the sellers – the parents, in this case – must also be willing to part with a share of their equity.
Is There A Minimum Gift Of Equity Amount?
In Canada, any mortgage for the purchase of a home must have a minimum 5% down payment. Therefore, any gift of equity would have to be at least 5% of the purchase price. For example, on a $400,000 purchase, that would equate to $20,000. For a mortgage to be conventional rather than default-insured, a minimum down payment of 20% of the purchase price is required.
Final Thoughts On Gifts Of Equity
When buying a home from a parent or other close family member, a gift of equity may be considered by the lender as an acceptable form of down payment – either in part or in full. It’s important for the buyer to keep in mind that they’ll still have to cover the closing costs from their own funds. For the seller, it may be advantageous to maintain their home within the family and avoid having to list the property with a real estate agent. Before offering a gift of equity they should consider the equity they’re giving up and any impact it may have on their finances over the long term. Of course, for any questions you may have about gifts of equity or purchasing a home, visit Edison Financial today.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.