Friday, January 12, 2007 - Article by: Lender411 Member
2006 was certainly an interesting year in our business. It was no 2005, 2004, or even 2001, for that matter. It was the Year of the Buyer. Buyers finally got the upper hand.
And the one thing buyers demanded this year was….money! They demanded money in repairs, money in upgrades, money in closing costs, and sometimes, money in their pocket.
The most surprising thing in my business, to me, has always been how little money people have saved.
Most loan programs simply require lenders to verify the borrower has two month's worth of house payments in cash reserves when they close escrow. The majority of people I deal with have trouble meeting that condition.
Forget down payments. They don't have it and that's why 100% financing is so popular. But how about the 2%-3% in closing costs required to purchase a home? They don't have that either. Enter seller contributions.
A seller contribution is when the seller of a home puts up some or all of the money needed toward the buyer's closing costs. Seller contributions can be negotiated at the time of a home purchase by having the seller pay closing costs rather than a reduction of the home sales price. Sometimes you can do a combination of both.
A lot of people are creditworthy of having a mortgage but they just don't have a lot of money in the bank. In these cases, seller contributions can mean the difference between a sale and no sale.
A Seller contribution is very easy to do. You simply disclose it to the lender. In most cases, these contributions range from 3%-6% of the purchase price. Some 100% financing programs now allow seller contributions up to 6%. It used to be capped at 3%.
Ever wonder how the homebuilder offers to make the buyer's payment for a year? They use the seller contribution to make these payments out of escrow. If you buy a $300,000 home and the builder is allowed a 3% contribution or $9,000 and your payment is $1,500 per month, there are your six months in payments.
Sometimes seller-contributed closing costs can help the borrower get a better interest rate by buying it down, making the home easier to qualify for.
Ever wonder how a homebuilder can offer 4.750% interest rates when the market is at 6.000%? They use seller contributions to buy down rate. Figure that every .250% of rate buy-down costs 1% in points or a loan discount fee. If the rate today is 6.000% and you want to buy it down to 4.750% that would cost 5 points in discount fees. You still have 1% left over for closing costs.
Are you offering these marketing possibilities to your clients? You need to get with your preferred lender to find out how you, too, can compete with the builders. Don't just use seller contributions to cover closing costs. You too can offer a home with a rate in the high 4.000's%.
Here is the catch: The amount of seller contribution cannot exceed the actual amount of closing costs and it CAN NEVER be given back as a cash incentive to the buyer.
This is where the dark side of my newsletter begins….
In the summer, I did a loan for Jerry and Lorraine buying their dream home of $850,000. The home had been on the market for around three months. They needed 100% financing and during the loan application, Jerry said to me, "Not only is this house a great deal but the seller is giving me $50,000 cash back at the close."
Jerry was planning on using this money for window coverings, new flooring and a plasma TV for the family room.
I cringed. It was painful to inform him that this was illegal. His agent hadn't told him this. He still went forward with the transaction at a reduced sales price of $800,000. A few months later we were able to still get him new flooring and window coverings through a home equity line of credit. The new plasma TV couldn't wait. It had to go on his credit card.
Cash-back is an American tradition. Cash rebates are offered on all sorts of products. Some credit card companies will give you cash-back on the purchases you make. In Las Vegas, we are used to giving out cash for better services at hotels, restaurants, clubs, and to avoid long lines.
However, cash back in a real estate transaction is illegal from a lending perspective.
Seller contributed closing costs, which are legal, are not paid in cash but as a credit from the seller to the buyer. They are fully disclosed and paid directly to the third parties through escrow.
This is different. I am talking about getting a nice big fat wad of cash or a big check at the close.
Here is how it works. Johnny Vegas goes out looking for a house. He finds one he likes listed at $350,000. He offers the seller $375,000 but he wants $25,000 to be kicked back to him at the close of escrow. Every one makes out on this deal! The buyer gets a big payday or new TVs or furniture or flooring. The seller gets his asking price. The real estate agent gets a bigger commission. The loan officer gets a larger loan and an increased commission. The lender gets a more sizable loan with more interest over 30 years. And the neighborhood keeps its value in a declining market.
So what's wrong with that? It's a buyer's market. Home builders are offering incentives as high as $75,000. So why can't you?
For one, the home builder does not offer incentives in cash. They offer incentives built into upgrading the property like flooring, pools, landscaping and sometimes, house payments for a year paid though escrow, or closing costs. Never cash back.
The problem with cash-back is that this transaction has defrauded the lender. The lender is tricked into making a loan that now carries incredible risk. The buyer has none of his own money in the property but has already made $25,000. The loan amount is higher, so if things get a little tight for the buyer, and that's a greater possibility, the buyer will simply walk away from the home.
If he walks away from the home, he does so with an artificially inflated value, which, in turn, raises property taxes for everyone and leaves the lender with a home they will lose a substantial amount of money on in the resale market.
Two major sub-prime banks with billions of dollars in loans recently closed their doors. These companies ran out of cash needed to repurchase loans that they had sold in the secondary market because the original borrowers had defaulted. Schemes like cash-back at close are, in large part, to blame.
For this to work an appraiser has to come in above the original asking price. This is a home that is now very likely upside down at close. The loan amount is higher than the actual value.
And what stops someone from going out and buying 10 houses concurrently in this scheme, adding $50,000 to each home, making $500,000 and then simply walking away leaving the banks with foreclosed properties that are upside down? It's a great business plan for someone who doesn't care about having their credit ruined, running from litigation and possible criminal prosecution, or the big-picture, economic implication of large sub-prime lenders going out of business.
There are people out there right now doing this. That's why banks are so strict about this.
The rule of thumb is that if a lender is not completely informed of ALL of the terms of the transaction in writing, then the transaction is illegal.
I have been personally burned by three transactions like this in the past year. It has been very costly for me financially. As a mortgage banker, I can be held personally responsible for the loans we make. In all these instances, I have come to learn, the buyer never even saw the house. That is a giant warning sign for you. You can be held liable as well. More signs are below.
A lot of you reading this newsletter right now are shocked. Some of you probably think this idea is legal and simply a way to compete in a buyer's market. Some will even write me to tell me that they had an attorney review these transactions and that this is perfectly legal.
I recently had to argue this with a respected, experienced real estate agent of 20 years. He was the listing agent on a $500,000 home. In the purchase agreement, it clearly stated the seller would give the buyer $75,000 at close. I called to tell him we could not do the loan this way. He argued that, he had spoken with a real estate attorney, and so long as this was disclosed in the sales contract, and the settlement statement at close, everything was legal and above-board.
He was 100% right. If you properly disclose the cash-back in the purchase agreement and the final HUD-1, you are not doing anything wrong. However try and find a lender who will do the loan. None will. This agent could not understand why we would not do the loan if he was doing everything legally.
If a lender finds out about this in the middle of the loan process, you can expect the transaction to be cancelled or to be asked to try and accomplish the end result a different way. Maybe a reduction in sales price or additional closing costs.
If it's not caught and the loan goes through, it might be caught in a post-closing audit. If this happens, the lender can call the Note due. This means you likely have 30 days to pay it off in full. You can find an "acceleration clause" in all mortgage loans. This allows the lender to demand immediate repayment if the borrower lied at all in his mortgage application.
Even though no lender will touch loans with cash back, the problem really isn't in the transactions where the kick back is written into the purchase agreement. Those can usually be explained to the buyer and seller and a restructuring of the transaction can be reached. The problem is in the ones where it's not disclosed. This is where fraud occurs. If you fail to disclose this kick back, and you have knowledge of it, you are an accomplice to loan fraud. If this is discovered in an audit of the file and you were involved, you can be held criminally, lose your license, fined and even face jail time.
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