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Proposal for a fairer home purchasing scheme

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  • Proposal for a fairer home purchasing scheme

    Hi,

    I am possibly in a similar situation to many others in that I currently have a sufficiently large income to be able to afford the repayments on even a relatively short-term mortgage, but would still have to wait quite a while before I can save up enough for the downpayment required. My recent credit history has not been particularly great as a consequence of some temporary hard times during the economic downturn, and so any mortgage applications I might make are likely to be turned down in any case. Furthermore, as a Muslim, I also have a fundamental issue with paying interest to a mortgage lender (particularly at an extortionate rate). And on top of this there is always the possibility of default if interest rates rise of if personal circumstances unexpectedly change.

    I recently came across an interview of a US-based couple on YouTube who managed to avoid paying interest on their house purchase by simply offering the seller the asking price for the house and then paying in instalments. This was during the housing crisis and the seller agreed to accept as he would otherwise have had to accept a lower offer, and did not mind being paid a slightly larger amount over a period of time. Of course there were some legal preconditions that needed to be satisfied, but the idea itself was quite simple.

    I liked this proposal, as basically it removed the middle man charging the extortionate interest rates (i.e. well above LIBOR), and instead paid a more reasonable "effective" interest rate to the seller, by offering a little extra than the seller expected for the house albeit to be repaid over a period of time, say 5 to 10 years. What I liked less about the idea was that the shorter repayment periods meant that regular large installment payments would have to be made to the seller, which in turn meant a relatively higher chance of default resulting in a significant loss for the buyer.

    After some consideration of the matter, I came up with another slightly different but related proposal, which is basically a kind of rent-to-buy or perhaps a kind of lease-purchase scheme which both completely avoids interest payments to any third parties and also significantly reduces the risk of default. The idea is still a little bit rough around the edges, but I think it would definitely help a lot of people to get onto the property ladder, as the up front payment/deposit* will typically only be between 4% to 8% of the property's value - the percentage being less for lower value properties. *Note that if the seller is willing to agree to it, then the initial deposit can be as little as three months' rent as per a standard rental contract - see the asterisked paragraph below.

    The basic idea is that the buyer and seller should agree upon an acceptable sale price were the house to be purchased immediately in cash. They will also agree upon a maximum repayment period (e.g 10 years) and an effective "rate of return" (e.g. 2.5%), so that the actual amount paid to the seller will be higher than the sale price due to the deferred repayment. The buyer and seller will also agree a fair rental price, ideally kept fixed for simplicity, that will be paid each month to the seller. In the meantime, the buyer will save up his excess income so that at the end of the agreed repayment period, the buyer can make a lump sum payment which, together with the rent and initial deposit, will be sufficient to pay the seller in full. If at any point the buyer cannot keep up with the rental payments, then the seller will retake ownership of the house.

    In order to protect the seller against their defaulting, the buyer needs to make an up front payment equivalent to twice the stamp duty based upon the sale price, as well as three months rent, so that the seller has time to find a new tentant or buyer. This money, and all subsequent payments by the buyer (including the compulsory rent and optional excess payments) will be held in an escrow account.

    There can also be an optional initial downpayment which can be agreed upon in exchange for proportional equity in the house - however this share will be retained by the buyer even in case of default. Similarly, the seller can, with the buyer's permission, take from the excess amount in the escrow account at any time in exchange for a proportional amount of the outstanding equity in the house. Again, because this payment is in excess of the rental payments, such equity share will be retained by the buyer even in the case of default. Default will be deemed to have occurred if making a compulsory rental payment would cause the balance in the escrow account (plus any amount withdrawn by the seller), to become less than the required deposit of twice stamp duty + 3 months rent.

    Also, the repayment period should be considered as a "maximum" repayment period - if it happens that the buyer is able to make a full repayment for the house some time before the repayment period has elapsed (e.g. 5 years rather than 10 years), then they will benefit from a reduced overall payment which will be the amount that would have had to be repaid had the repayment period between 5 years - this provides an incentive for the buyer to repay as quickly as possible.

    Because the buyer should be making regular overpayments into the escrow account, if their circumstances change unexpectedly, there will be a buffer amount from which rental payments will continue to be paid making the chances of default relatively low. Also, even if the overpayments made into the escrow account are not sufficient to cover the entire balance at the end of the repayment period, he should nevertheless by then have saved enough money to either borrow the remainder from friends and family - or even from the bank if necessary, with the house itself as security.

    I have already put together a detailed spreadsheet which carries out the necessary calculations in some detail. Consider, for example, a house with an asking price of £500,000. The parties may agree upon a sale price of £475,000, say, were the house to be purchased in cash immediately, an effective fixed rate of return for the seller of 2.5%, a maximum repayment period of 10 years, and a fixed fair rent of, say, £2,000. Then according to my calculations, assuming that the seller does not withdraw any excess amount from the escrow account beyond the required rental payments, the buyer will need to make an initial total payment of £38,500 (including stamp duty to take ownership of the house, deposit of stamp duty + 3 months rent, and £2,000 for legal fees etc) and would pay to the seller a total of £575,532 over the 10 year period (consisting of 120 monthly payments of £4,627 and a final lump sum transfer of £335,532 - the latter including the initial deposit of £20,250). This would represent a savings of £127,584 as compared with a mortgage with a fixed rate of 4%, say, which he might have been offered by the bank.

    *Even though the required up front payment is relatively low (typically between 4% and 8%) of the value of the property, this could still be something of a barrier to entry for some time. A suggestion to overcome this, should the seller agree to it, is that the buyer start off by simply making rental payments (without taking ownership of the house) with an initial 3 month deposit as per a standard rental agreement, and then only transfer to the full blown purchase agreement, including paying the stamp duty and additional stamp duty deposit to take ownership of the house, once he has saved enough money for the deposit at a later date, which could be the final repayment date in the extreme case - then the subsequent payments will continue as if the full agreement had been made right from the start.

    Of course each of the above schemes requires that the seller is willing to accept deferred payment for the house. This will typically require that any mortgage has been completely paid off (or that it can be paid off given the agreed upon downpayment), and that the purchaser does not require the cash up front to purchase another property (e.g. properties advertised as "No Onward Chain"). Since the seller is not an interest charging bank, and is likely to only receive a rate of return well below LIBOR on his own savings (which is next to nothing currently in any case), then he will still do quite well out of the deal on the suggested 2.5% fixed return.

    I would expect that there would be some reluctance for people to take up this scheme initially as no-one has really done it before. On the other hand I think many people would quickly warm to it if the process were formalised via an established and recognised legal contract - are there any property lawyers willing to put one together based upon the above? (either volunteer, or name your price) - and if a reputable organisation (ideally non-profit) or business were set up to oversee it.

    Indeed, if anyone thinks that this idea is sound, then I think that there is possibly a good opportunity here to set up a business which establishes a standardised formal process for such house purchases – the business would look after the legal paperwork and the escrow accounts (which will be viewable by clients via a web portal) and administration on their behalf for a reasonable up front fee plus a small monthly maintenance charge. Everything should of course be kept as transparent as possible so that there is no chance for any party to take advantage of another.

    Well the above summarises my new house purchasing proposal - please accept my apologies for its length, but I hope at least that it is clear! I would be very interested to hear what people think, positive or negative. Ideas for improvement and any constructive critism will, insha'Allah, be well received.

    Best wishes,

    Sabbir.

  • #2
    Re: Proposal for a fairer home purchasing scheme

    Originally posted by sarahman View Post
    Hi,

    I am possibly in a similar situation to many others in that I currently have a sufficiently large income to be able to afford the repayments on even a relatively short-term mortgage, but would still have to wait quite a while before I can save up enough for the downpayment required. My recent credit history has not been particularly great as a consequence of some temporary hard times during the economic downturn, and so any mortgage applications I might make are likely to be turned down in any case. Furthermore, as a Muslim, I also have a fundamental issue with paying interest to a mortgage lender (particularly at an extortionate rate). And on top of this there is always the possibility of default if interest rates rise of if personal circumstances unexpectedly change.

    I recently came across an interview of a US-based couple on YouTube who managed to avoid paying interest on their house purchase by simply offering the seller the asking price for the house and then paying in instalments. This was during the housing crisis and the seller agreed to accept as he would otherwise have had to accept a lower offer, and did not mind being paid a slightly larger amount over a period of time. Of course there were some legal preconditions that needed to be satisfied, but the idea itself was quite simple.
    There are so-called "Islamic Mortgages" available, which claim that they do not charge interest, but do otherwise charge a similar "fee".

    However, the danger of multi-installments is multi-fold - as you pointed out yourself, you had credit problems during the downturn, and the sad fact is that the downturn is anything but over.

    Additionally, mortgages tend to have a default term of 25 years, and expecting both parties to be good with this is expecting too much I think. A big reason why the banks are involved in lending is that they are big enough and experienced enough to see through a sale to conclusion and enforce payments.

    Otherwise the danger is, in a private part payment scheme, the seller would be left having to chase payments with no recompense whatsoever.

    Comment


    • #3
      Re: Proposal for a fairer home purchasing scheme

      Originally posted by brian View Post
      There are so-called "Islamic Mortgages" available, which claim that they do not charge interest, but do otherwise charge a similar "fee".

      However, the danger of multi-installments is multi-fold - as you pointed out yourself, you had credit problems during the downturn, and the sad fact is that the downturn is anything but over.

      Additionally, mortgages tend to have a default term of 25 years, and expecting both parties to be good with this is expecting too much I think. A big reason why the banks are involved in lending is that they are big enough and experienced enough to see through a sale to conclusion and enforce payments.

      Otherwise the danger is, in a private part payment scheme, the seller would be left having to chase payments with no recompense whatsoever.
      Hi Brian,

      Thanks for your considered response. I am aware of so-called "Islamic" mortgages, however as you intimate, these are in practice little other than conventional mortgages with a few terminological adjustments. Fundamentally I agree with the opinion that, "if it looks like interest, then it is interest", and "Islamic" mortgages simply are not Islamic. Tarek ElDiwany, who is the author of the book "The Problem with Interest" and producer of the documentary "Why We Are All in Debt" (viewable on YouTube), makes this point very clearly in a number of perspicacious editorials on his Islamic Finance webpage at www . islamic-finance . com.

      I agree with you regarding long term agreements of this type, which is why would not recommend the scheme I propose unless the buyer is in a situation where he expects to be able to purchase the property within a maximum period of 10 years, and ideally within 5 years. However, if a seller is willing to agree to a longer term, then so be it. Obviously such a short repayment term will require that the buyer have a sufficient source of income to be able to afford this. On the other hand, the risk of default should be relatively low, as the buyer is only actually required to pay fair rent each month. In the worst case of default, he will lose his initial deposit and will have paid fair rent for staying in the property, and the seller will have received fair rental income but will still own the house.

      I agree that enforcement could be an issue - which is why a sound legal contract is needed, and the payments need to be held in an escrow account. If the buyer defaults, the deposit (twice stamp duty plus three months rent) goes to the seller to reclaim the house, and so the seller should not be in a situation where he has no recompense. In the case where the seller agrees to let the buyer rent until he can afford the deposit, then this should essentially be the same as any other rental agreement as the seller will still have ownership of the house.

      The main potential difficulty I can foresee is actually forcing an unwilling buyer who has defaulted to actually vacate the property - though I am fairly sure that the situation is the same as with tenants not leaving a property once the rental period is over and standard procedures (whatever those are) can presumably be followed to ensure that they leave. As I mentioned, I think there needs to be an organisation or business overseeing such agreements whose responsibility it will be to ensure that the legal aspects of the agreement are enforced in an efficient manner.

      Best wishes,

      Sabbir.

      Comment


      • #4
        Re: Proposal for a fairer home purchasing scheme

        It's an interesting proposal but the concept is built entirely on trust - which may work for some, but our legal and tax framework would do little to support those on the losing side of failed arrangements. The second point is that a purely private vendor (one selling their main residence) is unlikely to want to be tied to a former property for years on end and becoming, in effect, an accidental landlord. I think the banks have some explaining to do but at least under the current system, you sell your house and walk away with your money - and therefore, the freedom to get on with your life.

        Comment


        • #5
          Re: Proposal for a fairer home purchasing scheme

          Originally posted by Jeannie D View Post
          It's an interesting proposal but the concept is built entirely on trust - which may work for some, but our legal and tax framework would do little to support those on the losing side of failed arrangements. The second point is that a purely private vendor (one selling their main residence) is unlikely to want to be tied to a former property for years on end and becoming, in effect, an accidental landlord. I think the banks have some explaining to do but at least under the current system, you sell your house and walk away with your money - and therefore, the freedom to get on with your life.
          Hi Jeannie,

          I agree with you that most sellers will want their cash up front so that it can be invested in other ways. This scheme is most likely not going to be suitable for them. Rather, it would be geared towards those (admittedly minority of) sellers that already own their house outright, do not need the cash up front, and do not mind essentially "helping" someone else purchase their property that might not otherwise easily be able to, or indeed might not want to, take out a mortgage to do so. Typical sellers for example might be those who would like to downsize now that their children have moved out of the family home.

          It is also intended for buyers, like myself, who do have sufficient income to be able to purchase the house in instalments over a relatively short period of time. So while one can argue that it requires an element of altruism on the part of the seller, given that they can negotiate a rate of return with the buyer that is acceptable to them, I do not think this kind of seller would be particularly disadvantaged in any way. Moreover, it could well mean that their property will become available to a much larger potential pool of buyers - particularly end-of-chain buyers who do not have another property to sell.

          I am not sure what you mean by someone being on the "losing side of failed arrangements", or what you mean when you say that our legal and tax framework would do little to support them - I woud appreciate it if you could clarify this statement, so that if such issue do exist, we can try to figure out how the scheme can be adapted to mitigate them.

          As I see it, in the worst case scenario for the seller, they will, as you say, have become an "accidental landlord", but this is hardly a disaster as they will have earned rental income on the property and will still have the property to sell. The real loser would be the buyer, who would lose his initial deposit, but in this scheme the likelihood of default should be much lower than for a conventional mortgage as it is geared particularly towards buyers who can afford to save significantly in excess of their monthly rental payments - and note that these payments are fixed in advance and are not subject to interest rate fluctuations, which I feel gives the scheme a tremendous advantage over conventional mortgages. Only a very irresponsible buyer would attempt to purchase a house via this scheme when he knows that he cannot comfortably afford to pay the fair rent - but this is true for conventional mortages as well.

          I do not agree that the concept is built entirely on trust. This might be the case were the two parties to deal directly with each other, and if the deposit and rental payments were not paid into an escrow account. However, my proposal is that there will be a firm legally binding contract and that the entire process should be overseen by a third party organisation whose responsibility it will be to ensure that everything remains transparent and above board. Perhaps the government could take responsibility for administering the scheme, or some government-supported non-profit body. I doubt that many people would complain if a fairer alternative home purchasing option were to become available where the chances of successfully buying or selling a property did not depend entirely upon whether banks felt that they could squeeze enough profits out of the deal to satiate their own lust for money at the buyer's expense.

          Best wishes,

          Sabbir

          Comment


          • #6
            Re: Proposal for a fairer home purchasing scheme

            Originally posted by sarahman View Post
            As I see it, in the worst case scenario for the seller, they will, as you say, have become an "accidental landlord",
            Worst case scenario, the seller doesn't get all of their money, and has to pay thousands in legal fees to address the issue, complicated further by the fact the new "owner" will have automatic habitation rights!!

            Originally posted by sarahman View Post
            I do not agree that the concept is built entirely on trust.
            Of course it is! Otherwise, feel free to lend me £500k and I promise to pay it back over 25 years at no interest.

            Comment


            • #7
              Re: Proposal for a fairer home purchasing scheme

              Originally posted by brian View Post
              Worst case scenario, the seller doesn't get all of their money, and has to pay thousands in legal fees to address the issue, complicated further by the fact the new "owner" will have automatic habitation rights!!
              The scheme requires that the buyer pay a fairly hefty deposit into an escrow account to allow the seller to retake ownership of the property in these circumstances. There should be a third party business or organisation (ideally a large, established one) overseeing the process to ensure that payments are made on time, to maintain the escrow account, and to enforce the contract in case of default.

              Originally posted by brian View Post
              Of course it is! Otherwise, feel free to lend me £500k and I promise to pay it back over 25 years at no interest.
              Perhaps you have misunderstood. This is nothing like an "interest-free" loan - indeed the buyer and seller mutually agree a rate of return for the seller up front. Furthermore, the entire process should be overseen by a third party that will also be responsible for looking after the escrow account, so the buyer and seller will not be dealing with each other directly, but through an intermediary.

              Comment


              • #8
                Re: Proposal for a fairer home purchasing scheme

                Originally posted by sarahman View Post
                Perhaps you have misunderstood. This is nothing like an "interest-free" loan - indeed the buyer and seller mutually agree a rate of return for the seller up front. Furthermore, the entire process should be overseen by a third party that will also be responsible for looking after the escrow account, so the buyer and seller will not be dealing with each other directly, but through an intermediary.
                Ah - you've just reinvented the mortgage.

                Comment


                • #9
                  Re: Proposal for a fairer home purchasing scheme

                  Originally posted by brian View Post
                  Ah - you've just reinvented the mortgage.
                  Hi Brian,

                  I think "adapted" would be a better word than "reinvented", but I am glad that you do recognise the proposed scheme as a mortgage of sorts. As I have tried to explain in some detail above, the whole point of the scheme is that it is actually much fairer than a conventional mortgage, the main differences being:

                  (i) the barrier to entry is much lower, as the minimum required deposit/downpayment is typically going to be around 5% +/- 3%, with the option of deferring this deposit payment should the seller agree to it

                  (ii) the effective interest rate will generally be much lower than the bank lending rate, and is fixed and mutually agreed upon up front - as a consequence the (minimum) payment schedule is fixed and known in advance

                  (iii) the likelihood of default is very low, as the buyer is expected to be able to afford to save significantly more than the minimum monthly rent, and these excess savings act as a buffer against temporary hardships

                  (iv) there is a bonus rather than a penalty for early payment

                  (v) the seller must be willing to accept payment in installments over time with an effective interest rate mutually agreed with the buyer (actually the time value of the property rather than the time value of the money lent)

                  (vi) the greedy middle man (i.e. the bank) is cut out, the result being a much fairer home purchasing scheme

                  I hope the above is clear.

                  I have prepared an Excel spreadsheet which carries out detailed calculations of payment schedules etc based upon the above. This will allow people to experiment with different parameter values, and hopefully give them a better feel for how the scheme works.

                  The main parameters which can be changed on the sheet are in red, and include the following:

                  (i) The Agreement price (i.e. the cash amount the seller would accept if the property were to be sold immediately)

                  (ii) The current fair rent for the property (to be mutually agreed)

                  (iii) The seller's desired return rate (i.e. time value of the property, to be mutually agreed) - 2.5% is suggested

                  (iv) The downpayment, if any

                  (v) The maximum repayment period

                  (vi) Whether rental payments should remain fixed, increase annually, or increase monthly over time

                  (vii) Legal fees, etc

                  (viii) Number of months deposit (including 1st month'e rent) - 3 months is suggested

                  (ix) The actual monthly payments made by the buyer to the reserve/escrow account

                  (x) Any amount the seller withdraws each month from the reserve account in exchange for equity in the house

                  Note that the sheet does not currently take into account the possibility of a deferred exchange of ownership - I will insha'Allah add this in due course.

                  Although the calculations are a little complex (it would probably take a brave person to check them), I do believe that they are correct. Nevertheless if anyone does happen to spot any errors or omissions, I would appreciate it if they were to let me know so that I can make the necessary additions and/or corrections.

                  Best wishes,

                  Sabbir
                  Last edited by Nickp; 09-03-2018, 04:15 PM.

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