By Jack Guttentag
Saturday, March 8, 2008
Q: The market is not doing well here, and we 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 close to it. Any part of the $8,000 that is not needed to pay lender fees or third-party fees can be used to pay points that reduce the borrower's interest rate. It will not end up back with you.
It is common practice for a home seller to pay all or part of the buyer's mortgage settlement costs. Paying $308,000 for a house with the seller committed to paying $8,000 in settlement costs is better for a cash-short buyer than paying $300,000 without the commitment because it permits a larger loan and therefore requires less cash.
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 $38,000: $30,000 for the down payment, plus $8,000 in costs. When the price is $308,000 and the seller is paying $8,000 toward closing costs, the buyer needs only $30,800.
For this to work, the appraiser must report that the house is worth $308,000, and the seller's contribution must fall within the lender's guidelines. Lenders restrict contributions based on how much the buyer is putting down. The common limit with 10 percent down is 3 percent of the price, so in my example, the contribution would be an acceptable 2.6 percent.
I sometimes run into larger contributions that don't fall within lender guidelines, in which payment by the seller is made outside of closing so it can be concealed from the lender. Don't let anyone talk you into doing that; it is fraud.
A seller should view a sale price of $308,000 combined with a commitment to pay up to $8,000 in costs as equivalent to a price of $300,000. In states with transaction taxes, the tax would be a little higher because of the higher price, but that is too small to worry about.
A higher price combined with the seller's commitment to pay settlement costs can make the transaction feasible for a cash-constrained borrower. If the buyer in my example can come up with $30,800 but not $38,000, the seller can make the deal work by raising the price and paying the costs.
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 lender fees and third-party charges 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 percent of $308,000) by about 0.625 percentage points.
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 up in the broker's pocket. The buyer can protect himself against this by negotiating the broker's fee from all sources in advance and putting it in writing. The broker will have no incentive not to pass through the lowest possible rate and will prevent any escalation of lender fees.
If the buyer is dealing with an avaricious loan officer employed by a lender, the $5,000 probably would be used to pay points, but the interest rate may not be any lower than it would have been without the payment. The loan officer might tell the buyer that the $5,000 bought down the rate from 6.25 percent to 5.5 percent, but 5.5 percent might have been the correct rate without the payment.
If the lending officer is the sole custodian of price data, the buyer is at a severe disadvantage. Generic market price data, such as those published by Freddie Mac or Bankrate.com, are some help but not much. The buyer needs to know the price on his deal, and he needs to be able to monitor it until his price is locked. The only way to do this is to access online sites that provide transaction-specific prices.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.
Copyright 2008 Jack Guttentag
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