Q: What is the down payment?
A: The down payment is the property value less the loan amount. It is not the same as the borrower’s cash outlay if some of that outlay is used for settlement costs. On a newly constructed home, the land value can be part or all of the down payment.
Q: If the appraised value of a home exceeds the sale price, can the difference be applied to the down payment?
A: No, the property value upon which down payment requirements are based is the lower of sale price and appraised value. An appraisal higher than the price is disregarded.
But there is an important exception, called a gift of equity, where the home seller is someone near and dear, usually a family member, who is willing to sell below market value. In such cases, the lender will probably require two appraisals, and the seller must follow Internal Revenue Service rules to avoid gift taxes, but those are minor nuisances.
Q: Can a home seller contribute to the buyer’s down payment?
A: No, because of a presumption that such contributions will be associated with a higher sales price. However, subject to limits, home sellers are allowed to pay purchasers’ settlement costs. This reduces the cash drain on purchasers, allowing more of it to be used as down payment.
Q: Can the lender contribute to the buyer’s down payment in exchange for a higher interest rate?
A: No, but lender rebates or "negative points" can be used to pay settlement costs as a possible alternative to seller contributions.
Q: Can cash gifts be used as a down payment?
A: Only if the gift comes from a relative or live-in partner who can document its source. Gifts from parties to the transaction such as home sellers or builders are not acceptable as down payment funds because of the presumption that the gift affects other parts of the transaction, especially the sale price.
The lender must also be convinced that the gift is not a disguised loan with a repayment obligation that might reduce the borrower’s ability to repay the mortgage.
Borrowers who receive undocumented cash gifts can include them as part of their own funds if they can show that the funds have been in their account for at least 60 days. They should have two monthly statements issued after the funds are deposited in the account.
Q: Are there any substitutes for a down payment?
A: In principle, any collateral acceptable to the lender could serve as a substitute for a down payment. The only such substitute found in the U.S. is securities, which must be posted as collateral with an investment bank that also makes mortgage loans. Borrowers who do this are betting that the return on the securities will exceed the mortgage rate.
Mortgage insurance and second mortgages can also be viewed as substitutes for down payment. They do not provide the first mortgage lender with additional collateral, but they shift a major part of the risk of the low-down-payment loan to a third party who is paid by the borrower for assuming it. The payment is either a mortgage insurance premium or a relatively high interest rate on a second mortgage.
Q: Is it wise to withdraw funds from a 401(k) to make a down payment?
A: Withdrawing funds is very unwise, as you would be hit with taxes and penalties, but borrowing against your account might make sense, provided your employer allows it. The cost of borrowing against your 401(k) is not the loan rate, which you pay to yourself, but the return the money would have earned if left in the account.
The risk is that if you lose your job, or change employers, you must pay back the loan in full within a short period, often 60 days. Otherwise, the loan is treated as a withdrawal and subjected to taxes and penalties. Loans from a 401(k) cannot be rolled over into a 401(k) account at a new employer.
Q: What are the costs and benefits of making a larger down payment than is required?
A. The cost is measured by the rate of return you could earn on the money if you invest it rather than use it for a larger down payment. The benefit is measured by the mortgage interest rate, as that rate determines the interest savings on the amount you don’t borrow.
If you increase your down payment by $10,000 on a 4 percent mortgage, you earn 4 percent on the $10,000 you didn’t borrow.
A possible additional benefit arises when the larger down payment reduces the cost of the loan by lowering either the mortgage interest rate or the mortgage insurance premium.
My calculator 12a shows the total rate of return on investment in a larger down payment taking account of any such cost reductions.
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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