Best Use of Cash

Cash

Many people are hesitant to pursue buying a home because they lack the cash required to purchase a home. Total cash required to buy a home is the combined totals of down payment and closing cost. In this article, we will explore alternate sources of cash and best utilization of cash for homebuyers.

To see total amount of required cash needed to purchase a home in your price range, please run the AskChristee module ‘Buyer Qual’ or ‘Buyer Choice’.

Required Down Payments

The required down payment will depend upon which mortgage type is best suited to you.

1. Conventional loans require a minimum down payment of 3% of the purchase price.

2. FHA loans require a minimum down payment of 3.5% of the purchase price.

3. VA loans do not require a down payment. You can borrow 100% of the purchase price.

4. USDA loans do not require a down payment. You can borrow 100% of the purchase price.

Closing Cost

Closing costs are fees collected for things such as: Title Abstract, Closing Fee, Transfer Tax, Documentary Stamps, Location Survey, Lender Fees and Deposits into an escrow account for future payments of property taxes and property insurance.

Closing Costs are very much dependent upon the location you purchase your home. Quite often, closing costs will exceed the required minimum down payment.

For a complete understanding of Closing Cost, please see the article Closing Cost Guide.

Below are five options which are available to reduce the amount of savings required to buy a home.

1. Gift Funds. You may get help for down payment or closing cost with a gift letter. This must be a gift, without terms of repayment. A gift of funds may be used to cover down payment or closing cost on FHA, VA, or USDA loans. Depending on the conventional loan LTV (loan-to-value), there may be restrictions on the amount of the gift funds.

For FHA and VA loans, gift funds may come from a family member, a friend, an employer, or some other approved source. For conventional loans, the gift may be restricted to a family member. People who are considered relatives include a spouse, child, or other dependent, in addition to anyone related by blood, marriage, adoption, or legal guardianship.

If you are utilizing a gift as part of your down payment or closing cost, then you must obtain a letter from the donor with the following information:

• The donor’s name, current address, and home phone number
• The donor’s relationship to the client
• The exact dollar amounts enclosed
• The date of the fund transfer (in legible format MM-DD-YYYY)
• A clear statement from the donor expressing that no repayment is expected
• The donor’s clear signature
• The address of the property to be purchased

Some Lenders will also verify the donor’s capacity to give. In words, they will verify the donor’s bank statements.

2. Seller Credits. Depending on the loan type, a seller can pay a large portion of your closing cost. On a FHA or USDA loan, the seller can pay up to 6% of the purchase price. For VA loans, the concession is capped at 4% and conventional loans are somewhere between 3% and 9%, depending upon the LTV ratio of the loan.

3. Lender credits. A lender credit is money from your lender to help cover part of your closing cost. Your lender may offer you several thousand dollars in credit to cover most (or all) of those costs. The trade off for the lender credit is a higher interest rate on your loan.

The combination of Gift Funds and Closing Cost Credits could result in little or no money required to buy a home. All AskChristee Modules calculate total required cash to close.

4. Withdraw or borrow money from your 401(k) or IRA account.

A 401(k) account is savings designated for retirement. These funds are withdrawn from your paycheck and deposited in an account which is generally managed by an outside management firm. Your employer may also contribute monies to this account. In theory, the money is invested wisely and thus grows in value over a period of time until retirement years. Monies contributed to your retirement account are not taxed until you withdrawn them – generally at retirement at a lower tax bracket. Being that the money is earmarked for retirement, the government severely limits account holders’ access to the funds until you are 59 ½ years old.

To access funds in your 401(k) account in order to purchase a home you have two options (a) make an early withdrawal or (b) borrow the money from your account.

If you withdraw money from your retirement account prior to the statutory age, you incur a 10% early withdrawal penalty on the sum withdrawn. Additionally, account holders could owe regular income tax on the amount as early distribution from the account. You could also be subject to an early withdrawal penalty of 10%.

If you wish to withdraw money from your ‘retirement account’ to purchase a home, you’re making what’s called a hardship withdrawal. Withdrawals are generally limited to your contributions to the account. Generally, the IRS allows a ‘hardship’ withdrawal if the money is used for the down payment on a principal residence.

Borrowing funds from your 401(k) account may be preferable to an early withdraw due to two factors – you do not incur an early withdrawal penalty and you are not taxed on the money. Normally, a 401K loan is limited to $50,000 dollars or 50% of your contributions into the account, whichever is less.

A 401(k) loan must be repaid with interest, it is typically the prime rate plus one or two percentage points. The interest rate and repayment terms may be designated by your 401(k) plan administrator. You will need to confirm the repayment period, which could be as short as five years.

You may also make withdrawals from Roth IRAs, and some other IRAs. A withdrawal from one of these accounts may be preferable to taking money from a 401(k).

IRAs have special provisions for first-time homebuyers—people who haven’t owned a primary residence in the last two years. Withdraws up to $10,000 of earnings are tax-free if the money is used for a first-time home purchase. You may also take a distribution from a traditional IRA. As a first-time homebuyer, you can take a $10,000 distribution without owing the 10% tax penalty – the $10,000 would be added to your federal and state income taxes. If the distribution is larger than $10,000, a 10% penalty would be applied to the additional distribution amount and would be added to your income taxes.

5. Selling or Borrowing Against Assets

Borrowing Funds. Generally, lending guidelines prohibit borrowers from borrowing funds required to purchase a home. The exception to this rule is the ability to borrow against existing assets. For example, prior to making mortgage application, you could take out an auto loan on a car that was previously paid off. Of course, the new debt would be become part of the debt-to-income ratio for qualifying purposes.

HELOC loans. A HELOC loan is a line of credit (2nd mortgage) against real estate. If you intend to borrow funds secured by a property you already own, then you should secure the loan well in advance of making mortgage application of a new property. As part of the mortgage process, Lenders will question large bank deposit within the last 60-90 days. Of course, the HELOC payment will be included in your debt-to-income qualifying ratios.

Selling Assets. You may sell any existing asset to obtain funds to purchase a home. You can liquidate any asset such as a car, coin collection, or memorabilia. If the deposit from the asset sale is within 90 days of mortgage application, then make sure to maintain the sales receipt to verify the source of the deposit.

6. Real Estate Commissions. Some real estate agents (or brokers) may encourage buyers to utilize their services by offering a portion of the commission as a rebate to the buyer. Generally, this practice is legal, however, the real estate agent is considered an ‘interested party’ and as such limitations may apply. The agent contribution will be added to any seller concession to determine maximum amount of closing cost credit.

Example, a $400,000 purchase with $15,000 closing cost. Maximum mortgage concession is 4% or $16,000. The maximum concession cannot exceed actual closing cost therefore the max is set at $15,000. Assuming a seller credit of $10,000, in theory, the real estate agent could contribute $5,000 toward closing cost. It would be unusual for a real estate company to agree to a contribution this large. You should negotiate any agent concession (if any) prior to signing buyer agency agreement.

7. How much cash should I use when buying a house? Assuming you have more cash available than required to purchase your new home, you should evaluate the following considerations:

(a) Existing Consumer Debt. Consumer debts (credit cards, personal loans, and auto loans) carry a higher interest rate than mortgages and the interest in them are not tax deductible. It is for these reasons, that you should use ‘extra cash’ to payoff consumer debt rather than putting additional down payment on the purchase of a house.

(b) Payment per thousand. Below is a chart showing monthly payment per thousand borrowed.

30-year mortgage payment factors:

15-year mortgage payment factors:

How to use the chart:

Select an interest rate (top row) and multiply the amount to be borrowed per thousand by corresponding factor.

Example. If you have 10,250 in credit card debt and you want to know how much you mortgage payment will increase if you increase your mortgage by that amount.

Step 1. Divide amount by 1000. 10250/1000=10.25

Step 2. Multiply 10.25 by payment factor. 3% 30-year payment factor is 4.21. 4.21*10.25=$43.15

This means if you borrow an additional $10,250 your monthly mortgage payment will increase by $43.15.

Step 3. Compare this to your credit card payment. Be cautious when looking at minimum card payments. Generally, the minimum payment does not allow for principal reduction of your debt by paying the minimum amount each month; it could take 20-30 years to payoff your debt. The above $10,250 credit card debt may only require $25-30 per month. However, if the interest rate on the credit card were 12% (a deal for credit card), it would require a monthly payment of $105.43 to payoff the debt in 30 years. You will also pay over $27,000 in interest which is not tax deductible.

Would you rather pay $105.43 per month which is not tax deductible or $43.15 per month with interest is tax deductible?

(c) Rainy day fund. You may want to keep extra cash available for future emergencies.

AskChristee Modules such as ‘Buyer PreQual’ or ‘Buyer Choice’ will show the effects on putting additional down payment on the purchase of a home.