Look into the Minds of Madmen
For the purposes of today, we are going to journey behind the curtain into the mortgage industry. As simple as it may seem, the mortgage industry is infinitely more complex than most people realize. There are many rules, regulations, and guidelines that we follow that are not an arbitrary set of circumstances that some wizard (pay no attention to that man behind the curtain) has created. Rather, they are the result of years and years worth of experience and statistical probabilities. At the heart of any guideline discussion the essential question is: (if you are the bank) Will this loan perform?
There is certainly some give and take in the application of many of the rules and guidelines, but in some instances there is very little flexibility to be had. One such situation with little flexibility is seller concessions. There are three things a seller may pay on behalf of a buyer - points, closing costs, and prepaid items. Nothing else. The seller is not able to give any concessions or credits directly to the buyer for repairs, allowances (paint, carpet, etc), or down payment assistance.
There are certain instances when legitimate repairs need to be made and banks have systems in place for that. In these situations, the money necessary is given to a neutral 3rd party (generally an attorney) to hold until the work is completed. Once the work is done, the bank will re-inspect to make sure the work has been completed and the funds will be released to the contractor. This is generally referred to as an escrow hold-back and the bank will allow it because the buyer never has direct access to the funds. It can be tough to negotiate a hold-back as many lenders often want 1.5 to 2X the repair amount held in escrow. They have been around the block and know that there can be cost overruns, and they don't want to be left holding the bag.
Along a similar note, there are certain loans that allow for the seller to provide the entire down payment for the buyer. These are relatively rare and are often limited to first time home buyers (FTHB) and government loan programs. Also, it is generally required that a non-profit 3rd party is involved in this situation as well. The actual details can be quite complex, but I will summarize things and say that it is essentially impossible to have the seller directly give the down payment to the buyer with one exception. That exception? A direct gift is allowed from direct family members (parents to children, sibling to sibling, etc). The amount of the gift varies from 3% to 20%, depending on the type of loan. Again, the details and tax consequences can be fairly complex, so please feel free to email me if you have specific questions.
This information sets the table for a recent discussion I had with a potential client. The client called me as she had a condo under agreement for $165K. She was planning on putting 5% down, and the seller (a developer) had agreed to give her $4000 towards closing. The developer did not particularly care what she used the funds for. Her total closing costs came to approximately $3000. I suggested that we use the additional $1000 towards buying down her interest rate. The client then informed me that her attorney and the developer told her that she could just use the excess funds towards her down payment and reduce the cash she needs to bring to closing. I explained to her that while there was absolutely nothing illegal or immoral with what she wanted to do, lending guidelines simply won't allow it.
This client had also been talking to another mortgage professional, and the other mortgage professional told her that it would be no problem to apply the excess funds in the manner she wished. As a result, the potential client has decided to work with the other mortgage professional. My hope is that this client will close uneventfully and under the terms she has been quoted. My fear is that someone in underwriting or the closing department will catch the excess while reviewing the HUD, and the additional $1000 credit will be disallowed.
Forgive me for such a long post, but I want to delve further into the logic as to why this is a problem for banks. Banks have certain assumptions. One prominent assumption is that people generally value money they have earned and saved more than money that is given to them. Generally speaking this tends to be true. Banks also know that the more money a person puts down on a property, the more likely the loan is to perform. If we assume everything else is equal (job history, income, credit, etc) there are significantly different risks for a bank depending on whether someone is putting 20%, 10%, 5%, 3%, or 0% down.
Banks compensate for the additional risk in the form of a higher interest rate. In the above scenario, the client is trying to qualify for an interest rate based on 5% down, but she is not truly putting 5% down. It is very close, but there is a significantly different risk in lending to someone with 5% down in comparison to someone putting less than 5% down. Also, it's a slippery slope. A thousand dollars is not much money in grand scheme of things, but what about $1500? $2000? It becomes difficult to draw a line as to what's acceptable and what is not.
As a result, lenders have decided to limit a seller to contributing to the three things I mentioned above (points, closing costs, and prepaid items). They also limit the amount that can be contributed (between 3% and 6% with the contribution not to exceed actual costs). I will follow up with this potential client after closing. I am never a big fan of advising what other companies can and can't do (who am I to know the inner-workings of another company?), but I do have some serious reservations about what this client is being offered (based on my guideline knowledge of FanneMae, FreddieMac, and the 50+ lenders we work with). Hopefully she we be very happy and I will find out who she closed with and make sure they are added to our approved lender list. If not, maybe I can work with her on her next transaction and show her the way things are supposed to be done.
Thanks for reading and have a great weekend!
