"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?"
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. The reason is that 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. If the excess isn’t used to buy down the rate, it probably will end up in the pocket of the loan officer or mortgage broker. Where it will not end up is back with you.
It is common practice for home sellers to pay all or part of a 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 cash equal to 10 percent of $300,000, which is $30,000, plus $8,000 in costs, which adds up to $38,000. When the price is $308,000, the buyer needs only 10 percent of $308,000, or $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, where the 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 a fraud.
A seller should view a sale price of $308,000 combined with a commitment to pay up to $8,000 in costs as the equivalent of a price of $300,000. In states with transaction taxes, such as Pennsylvania, the tax would be a little larger on the higher price, but that is too small to worry about.
There is only one reason for a seller to select the higher price combined with a commitment to pay settlement costs, and that is to make the transaction feasible for a willing but 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 0.75 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 up 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. Upfront Mortgage Brokers (UMBs) do this as a matter of course. The broker will have no incentive not to pass through the lowest possible rate, and will also prevent any escalation of lender fees.
If the buyer is dealing with an avaricious loan officer (LO) employed by a 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. The LO 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 be the correct rate without the payment!
If the LO is the sole custodian of price data, the buyer is at a severe disadvantage. Generic market price data, such as that published by Freddie Mac or Bankrate.com, is 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 own price is locked. The only way to do this is to access online sites that provide transaction-specific prices. The best of these are the sites of Upfront Mortgage Lenders, which are listed on my Web site.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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