Should home-sellers pay the settlement costs of buyers?
Q. In an effort to sell my house I agreed to pay up to $8,000 of the buyer's closing costs. Is there anything I can do to keep the amount as far below $8,000 as possible?
A. At this point, no. If you agreed to pay "up to" $8,000 of the buyer's costs, you will almost surely end up paying $8,000, or very close to it.
If the buyer is astute, any part of the $8,000 that is not needed to pay the lender's fixed-dollar fees or third party fees will be used to pay points that reduce the borrower's interest rate. This is called "buying down the rate."
Points are lender fees expressed as a percent of the loan balance, and lenders trade off points against the interest rate. Low rates require high points, high rates command negative points called "rebates." Points are settlement costs and are therefore covered by the seller's commitment. The astute borrower will use any part of your $8,000 that is left over as points that reduce his rate.
If the borrower is not aware of his option to buy down the rate, the excess very likely will end up in the pocket of the loan officer or mortgage broker. Where it will not end up is back with you, the seller.
The practice of home sellers paying all or part of a buyer's mortgage settlement costs arises from the effort to qualify potential homebuyers who don't have quite enough cash. A potential home seller looking to net $300,000 for her house may broaden the market by pricing the home at $308,000 combined with an offer to pay up to $8,000 in settlement costs. Paying $308,000 for a house with the seller committed to paying $8,000 in settlement costs permits a larger loan and therefore requires less cash from the cash-short buyer than paying $300,000 without the commitment.
For example, assume the borrower is putting 10 percent down and settlement costs are $8,000. If the price is $300,000, the buyer needs cash equal to 10 percent of $300,000, which is $30,000, plus $8,000 in costs, which add to $38,000. When the price is $308,000 with no costs, the buyer needs only 10 percent of $308,000, or $30,800. Hence, if the buyer can come up with $30,800 but not $38,000, the higher price with a settlement cost commitment has succeeded in expanding the market.
The major proviso is that the appraised value must match the price inclusive of the settlement costs. In the example, the appraiser must report that the house is worth at least $308,000. If the house is appraised at $300,000, the buyer's cash requirement won't be reduced. In the years prior to the financial crisis, appraisals were largely accommodative, today less so.
A second proviso is that the seller's contribution must fall within the lender's guidelines. Lenders restrict contributions, based on how much the buyer is putting down. Fannie Mae and Freddie Mac set a limit of 3 percent of the price when the down payment is 10 percent, so the contribution in my example would be an acceptable 2.6 percent. Note that FHA allows contributions up to 6 percent regardless of the down payment.
I sometimes run into larger contributions where the payment by the seller is made outside of closing so it can be concealed from the lender. That is a fraud.
The cash constrained buyer who agrees to pay $308,000 to receive an $8,000 contribution should aim to use the $8,000 to pay fixed-dollar lender fees (those not related to loan size) plus third party charges such as title insurance, and use whatever is left to buy down the interest rate by paying points. For example, if fixed-dollar lender fees are $800 and third party charges $2,200, the $5,000 remaining should buy down the rate on a 30-year fixed-rate mortgage of $277,200 (90 percen of $308,000) by about .75 percent.
But an avaricious loan provider can easily thwart this strategy unless the buyer knows how to protect himself. If the buyer is dealing with a mortgage broker, the $5,000 may end in the broker's pocket as extra compensation. The buyer can protect himself against this by negotiating the broker's fee from all sources in advance, and putting it in writing.
If the buyer is dealing with an avaricious loan officer (LO) employed by the lender, the $5,000 likely will be used to pay points, but the interest rate may not be any lower than it would have been without the payment. To protect herself, the buyer needs to know the competitive rate on her transaction inclusive of the $5,000 in points. She also needs to be able to monitor the price until it is locked. The only effective way to do this is to access an online site such as mine that provides transaction-specific prices.
Buyers should be particularly wary of offers by builders that they will pay all settlement costs if the buyer uses the builder's preferred lender. The interest rate paid by buyers accepting this attractive-sounding offer is bound to be higher than the rate available from a competitive lender providing a rebate large enough to cover the same settlement costs.
• Contact Jack Guttentag via his website at mtgprofessor.com.
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