If you’re going to buy a home you’re going to have to come up with three pots of money – 1) a down payment, 2) financing, and 3) money for closing costs. The biggest chunk of money you’re going to need – the financing – will be covered by your mortgage. And in order to get the mortgage you’re going to need down payment money. FHA requires at least 3.5% of the purchase price as a down payment. Some conventional mortgages only require 3.0% but most look for 5%, 10% or 20% down.
Where are you going to get your down payment money? Some home buyers wait to buy a home until they have saved up enough for a down payment. That’s admirable, but not always necessary. You might qualify for down payment assistance, such as from Minnesota Housing, in which case the most you’ll need of your own money would be $1,000. Another option could be “Gift Funds.” You can’t borrow down payment money, but it can be given to you if you’re getting an FHA mortgage. To learn more about this option, ask your loan officer about a “non-occupying co-borrower.”
There’s another chunk of money you’re going to need – quite likely even more than what you’ll need for a down payment – closing costs money. First of all, what are closing costs? Closing costs are a collection of fees, expenses, and pre-paid escrow items that you will incur in the purchase of your home. Closing costs fluctuate with the price of the home, the kind and amount of financing, taxes and insurance amounts, lender fees, the title company you use, and the date of closing. Depending on all these variables, closing costs typically total from 3% to 5% of the home’s selling price. For instance, let’s say you want to purchase a home for $200,000 using an FHA mortgage, and you’re going to close on March 25. Total closing costs will be about $7,600 (3.8% of the purchase price).
Where are you going to get your closing costs money? Gift funds aren’t allowed and generally speaking, you can’t borrow money for closing cost. You could save it up, but that might take a while. Or, you can create the money. Now, I didn’t say “make the money,” I said “create” it.
How can you create closing costs money? Simple – give it to the seller and have the seller give it back to you. In the lower- to mid-price ranges, this is the most common way that buyers come up with closing costs money. Here’s how it works: you offer the seller a purchase price and in that offer you state that you require the seller to pay a certain amount of money toward your closing costs. The amount you ask for would be as close to the actual total amount of closing costs that you and your real estate agent can estimate. If the seller agrees to this deal, you’ve got your closing costs covered. Simple.
Okay, that looks pretty easy and straight-forward. It looks like you negotiated for the seller to pay your closing costs; it looks like you got something out of the seller. Yes you did, but you paid for it. Let’s look deeper into your offer. Let’s say you offered the seller $200,000 and required him to pay $7,600 toward your closing costs. You are paying $200K for the home, but the seller is only getting $192,400. This is called the seller’s net. The reason the seller said “yes” to this deal is because a net of $192,400 satisfied him. What if you would have offered the seller $192,400 and did not require him to pay anything toward your closing costs? The seller would have said “yes” to that deal as well. It’s a lower selling price but it’s the same net amount to the seller. So no matter how much you offer the seller, if you require the seller to contribute toward your closing costs, then the seller would have always accepted a lower offer in which they did not contribute toward your closing costs. In other words, if money for your closing costs is in the price of the home, it’s you who actually is paying for your closing costs.
Is this a smart thing to do? Probably, because it gets you where you want to go – into a home sooner rather than later. But if you’re the analytical type (like me), let’s break it down and look at your options. Back to our example: $200K purchase price, FHA 30-year mortgage at 4.75%, 3.5% down. The monthly payment on this mortgage for principal, interest, and mortgage insurance is $1,162. In that $200K price is $7,600 in closing costs. If the purchase price were reduced to $192,400 then the monthly payment would be $1,117. So it would cost you $45 per month to have the seller pay your closing costs. That’s 7.1% annual interest which isn’t bad.
There are also some upfront costs associated with getting this $7,600 that you should be aware of. As you go from a purchase price of $192,400 to $200,000 your down payment increases by $266, your upfront mortgage insurance increases by $73, mortgage registration tax goes up $18, your lender’s origination fee is $73 more, and you’ll pay $7 more in prepaid mortgage insurance. So in addition to the $45/mo ($540 for the first year) you’re going to pay an additional $437 in cash and fees for the higher purchase price. In year #1 that $7,600 will cost you $977 which is 12.86%. Still not as much as credit card interest, but something to be aware of none the less.
That analysis may be more nit-picky than necessary. But what’s important for you to realize is that by including closing costs in the price of your home, it’s going to cost you some additional upfront cash and fees, and because your purchase price is higher, it’s going to cost you more each month.
What are the advantages of having the seller pay your closing costs? Most importantly to you, like I said earlier, if you don’t have the extra $7,600, it gets you into a home now rather than waiting until you save $7,600. And it doesn’t really cost that much extra – a few hundred dollars up front and an extra $45 per month, in this example. Another advantage to paying the higher price with closing costs included is that the home may not appraise at the higher value. This could turn out to be to your advantage, as a buyer, because it would force the seller to consider selling the home at the lower appraised value (still including closing costs for you), thus saving you a few thousand dollars.
What are the disadvantages to you? As I’ve said several times, you’re going to pay a higher price for your home, which means you will be paying more than what the home is worth. In this market of declining home values, the idea of paying more than a home is worth should cause you to take pause. You’re going to pay a higher monthly payment for the home, so again, it’s costing you more but it’s not worth more. Another disadvantage is that paying a higher price drives up your mortgage insurance: upfront as well as monthly. And mortgage insurance nets you nothing. It doesn’t net you any additional equity in your home. In our example here, at the higher purchase price, you’ll pay an additional $73 in upfront mortgage insurance plus an additional $72 per year (for about 10 years).
Where does the seller stand on this idea of paying your closing costs? What are the advantages and disadvantages to them? The biggest advantage is that it gets their home sold. If you are a ready, willing, and able buyer, only limited by your lack of closing costs money, most sellers will eagerly pay your closing costs, as long as they get the net amount that they are satisfied with. As far as disadvantages to sellers, they’ll pay a slightly higher deed tax ($3.40 per $1,000 of selling price, so in our example it would cost them an additional $26) and a slightly higher selling commission to their real estate company (about $400 in our example). The biggest potential disadvantage of accepting a higher price for their home is that the home may not appraise at the higher price. In that situation they may feel forced to reduce the selling price in order to get their home sold.
Closing costs is one of the three pots of money you’ll need when you buy a home. You don’t have to wait to buy a home until you save up enough for both your down payment and closing costs. You can create closing costs money by working cooperatively with the seller. The seller gets their home sold and you get the home you want now. Win-Win!
