The role of closing costs in a purchase agreement can be confusing both for buyers and sellers. In the present market, it is customary for there to be sales concessions. A real estate sales concession can be many things including but not limited to price, repairs and yes, . . closing costs. Asking the seller to pay for closing costs, pre-paids and discount points is common. At the end of the day though, a buyer may have several value added considerations such as seller paid closing costs and repairs after an inspection contingency but the seller will (or at least should) always negotiate on the basis of what their net proceeds after all concessions will be.
The term seller paid closing costs is really a misnomer though. A more appropriate name would be buyer financed closing costs. This is because despite the fact that it can appear that the seller is paying for them, this isn't the case. The buyer always pays for closing costs but the question is how. Will the buyer have them rolled into the purchase price or pay for them with cash out of pocket or a combination of the two? These are the choices. No matter what choice is made, they are still technically paid for by the buyer. If this weren't the case and the seller actually paid for them, why is it that the IRS lets the buyer write off a portion of these costs on their tax return instead of the seller writing them off? It's because no matter how you slice it, the buyer pays them.
There are many benefits to a buyer when structuring their purchase agreement such that the seller pays closing costs. It can lower the cash required to close, extend the purchase price a buyer is able to offer, lower the eventual rate that the buyer gets, buy out mortgage insurance and many more. These various benefits should be weighed by a homebuyer prior to putting in an offer so they know that the offer structure they're submitting is the most intelligent structure to meet their objectives.
When contemplating the structure of an offer, a homebuyer should remember the limits that certain loan types have for seller contributions. Here's an outline:
1.) Conventional (loans backed by Fannie Mae and Freddie Mac)
- Over 90% LTV: maximum “seller paids” = 3% of the purchase price
- >75% LTV & < 90% LTV = 6% of the purchase price
- <75% LTV = 9% of the purchase price
- Investment properties at any LTV are capped at 2% of the purchase price
2.) FHA (loans insured by the Federal Housing Administration)
- All FHA loans are capped at 6% of the purchase price
3.) VA (loans insured by the Veteran’s Administration)
- All VA loans are capped at 4% of the purchase price
4.) RD (rural development loans)
- Rural Development loans are strange in that they don’t have a cap but most investors force a cap of 6% of the purchase price
Constraints on seller concessions for loan programs are not the only consideration. If a homebuyer is looking at foreclosures, they need to know that most bank owned properties where the property is owned by Fannie Mae or Freddie Mac (which is a lot of them) will only allow 3% of the purchase price in seller paid closing costs. Therefore, even if a homebuyer is planning on a FHA loan with 6% in seller paid closing costs, should they encounter one of these properties with a lower purchase price, they could be facing the decision of choosing between a higher interest rate or a higher down payment.
Managing the role that seller paid/buyer financed closing costs will play in a transaction is important and not to be left to the moment one is making an offer before consideration is given. Parties to a transaction shouldn’t get confused about who’s really paying them and make ill-informed decisions accordingly. It’s also important to ensure that a homebuyer’s loan officer and Realtor work well together to ensure that the offer structure is of maximum benefit to the buyer.