Saturday, December 29, 2007

FAQ: Seller Subsidies/Contributions to Closing Costs

I'm often asked how seller subsidies, (also known as “seller contributions” or “closing cost assistance,” work. When a buyer purchases a property, he can expect closing costs of about 3% of the transaction price. (This varies widely by jurisdiction—consult a local REALTOR for more details.) The closing costs are a combination of (1) fees to lenders, brokers, appraisers, and attorneys, and (2) prepaid expenses, e.g., paid-in-advance property taxes or hazard insurance. Many of the prepaid charges vary depending on the day and month in which you settle. For example, if you settle on the 25th of the month, you typically pre-pay 5 days of interest, whereas if you settle on the 10th of the month, you typically pre-pay 20 days of interest. For this reason, if a buyer needs to keep closing costs low, it sometimes pays to negotiate an end-of-month settlement. As a general rule, buyers cannot finance closing costs, so a buyer needs to show up at settlement with funds for both their down-payment as well as their closing costs.

Closing costs come off of the seller’s “net” or the amount of proceeds after expenses. Let’s say the seller is listing his home for $450,000 and his selling expenses (fees, etc.) are equal to 8% of the transaction. If he were to receive his full asking price, his “net” would be 92% of the total, or $414,000. In this example, the buyer would need to pay $13,500 in closing costs (3%) + his down-payment.

One negotiation tactic that is very common in this buyer’s market is to ask the seller to pay a buyer’s closing cost ($13,500 in our example), so that the buyer minimizes the amount of cash they need to spend to get into the house. The buyer may actually have the cash, but might prefer to hold onto it as savings, or apply to his down-payment, remodel a bathroom, to buy furniture, or whatever. Tip: You may see “seller contribution” clearly advertised in a listing—don’t let this drive your decision too much—in this market, almost any seller would be happy to contribute to your closing costs whether they advertise it or not. By stating it in a listing, though, in essence these sellers are simply saying “I’m willing to take less than list price.”

Now, getting back to our example, let’s say that a buyer wants to make an offer on that $450,000 home, but after discussing it with his agent, wants to pay only $430,000. (And for purposes of this example, let’s assume that the seller wants to “net” the fair market value of $430,000.) The buyer may offer less, or may ask for closing cost assistance, or a combination. So if the buyer wants his closing costs paid for, he might offer $443,500 and ask for a seller contribution to closing costs of $13,500. The seller then nets $430,000. The buyer would borrow the full $443,500—in essence “financing” his closing costs across the life of the mortgage—but would only need to write a check for the down-payment at closing.

Taking it one step further, if a buyer were to ask for both a price concession AND closing cost assistance, the seller would apply both to his net. In our example, it’s unlikely the seller would accept an offer of $430,000 AND provide a full $13,500 contribution because his net would only be $416,500 rather than the market value of $430,000.

From a buyer’s perspective, asking for closing costs is a good way to minimize cash out-of-pocket in the short term, but the trade off is that the buyer is paying interest (via the higher mortgage) for potentially years. Be careful, though—many lenders have a limit of how much a seller can contribute; they want you to have some “skin in the game” in today’s market! Additionally, review your contract carefully—sometimes any excess contribution is returned to the seller.

From the seller’s perspective, the financial difference of giving a price concession or a closing cost contribution is usually immaterial—the impact to the net is essentially the same. (The only difference is that any fees that are based on a percentage of the transaction price will be slightly higher; in our example, they would be based on the $443,500, and not the net of $430,000. Still likely a very small price to pay to get a buyer to the table!)

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