One of the biggest shocks of buying a home is finding out you need way more cash to close on a house than just a down payment. While it’s hard enough to save for the down payment, you’ll need more — often a lot more — in order to complete the transaction.
Exactly how much?
Well, if you are buying a home for $400,000 and need a 10% down payment, the total amount of cash that you may need to provide (or at least show) could look something like this:
| Cost | How much you need to save | Amount needed in cash |
|---|---|---|
| Down payment | 10% of $400,000 | $40,000 |
| Closing costs | 5% of $360,000 | $18,000 |
| Prepaid expenses | 2% of $360,000 | $7,200 |
| Utility adjustments | Estimated | $500 |
| Cash reserves | $2,000 mortgage payment x 2 | $4,000 |
| Total cash required | $69,700 |
Let’s break down what these numbers mean. And where possible, I’ll suggest ways that can reduce or even eliminate the additional cash requirements.
The down payment
This is the only cash outlay in the homebuying process that’s obvious to most buyers. It is usually expressed as a percentage of the purchase price of the property.
For example, if the home’s purchase price is $400,000, and you’re required to make a 10% down payment, you’ll have to pay $40,000.
With most lenders, if you want to avoid paying additional private mortgage insurance (PMI), you’re actually looking at a 20% down payment. But since coming up with 20% may be difficult for many first-time buyers, mortgage lenders have options with a minimum down payment of 10%, 5%, or — if you qualify for special FHA loans or VA mortgage loans — as little as 3.5%.
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Acceptable sources of funding for a down payment
Exactly where your down payment comes from will depend on the type of mortgage you are applying for. In some cases, the down payment must come from your own funds, such as your bank account. But in other cases, it can come from a gift or even be borrowed from approved agencies.
Conventional loans
Conventional loans (those that aren’t insured by the government like FHA or VA loans) tend to have the strictest rules when it comes to the source of your down payment funds. If you are making a down payment of 5% or 3% of the purchase price, the lender will typically want to see that the funds come from your own financial resources. That can include money withdrawn from a bank account, funds withdrawn or borrowed from an employer-sponsored retirement plan, or even the sale of a personal asset.
Typically, once you satisfy the “own funds rule,” the guidelines become more relaxed.
For example, on a conventional loan, if you’re making a 10% down payment, the lender may require 5% coming from your own funds, and 5% from a gift from a relative. But if the gift is equal to at least 20% of the purchase price of the property, the lender won’t require you to show evidence of your own funds at all.
FHA loans
FHA mortgages are insured by the Federal Housing Administration and have a more relaxed view of down payments entirely. Not only can the down payment come from either your own funds or from a gift, but they also allow loan proceeds from approved down payment assistance programs. It can make it possible to get 100% financing on an FHA loan.
VA loans
With VA mortgages (government-backed loans for veterans, service members, and surviving spouses), the down payment isn’t typically an issue. VA loans normally provide 100% financing, which makes the down payment a moot point.
Where you can’t get down payment funds from
Two generally prohibited sources are:
- Cash
- Unsecured loans
By cash, I mean currency you store at home or in a safe. Any money you invest into a home has to pass through a financial institution to be considered a legitimate source of funds. In addition, cash savings in the form of currency can’t be verified as being valid. After all, mortgage lenders want to avoid money laundering.
Unsecured loans are also a no-go. If you have any ideas to provide a down payment from a credit card advance or the proceeds of a personal loan, this will be rejected by the lender. Not only does it indicate an inability to accumulate funds for the down payment, but it also creates an additional debt obligation.
Final note about the down payment
FHA and VA loans may not require a large down payment amount, but just because you don’t have to put a lot down doesn’t mean you shouldn’t. The less you put down the higher your mortgage payment will be and the more fees and interest you will pay.
Make sure you can comfortably afford your mortgage payment. If the monthly mortgage payment is too big, keep saving and make a larger down payment at a later time. Private mortgage insurance is also based on the amount of the loan, so the more money you can put down the lower your monthly mortgage payments will be.
Closing costs
This is where things start to get a little complicated. This is because the cash outlay to make the purchase becomes (often) much higher than the down payment alone.
Depending on your location and mortgage lender, closing costs may range from 2% to 6% of your loan amount. So, on a $400,000 mortgage with 10% down, your loan amount is $360,000. That means you’ll need to come up with between $7,200 and $21,600, in addition to your down payment.
However, there are two factors to keep in mind:
- Closing costs vary from one state to another. This is due to differences in either the real estate transfer tax, or mortgage “stamps” (government taxes collected based on a percentage of your mortgage loan amount). They can also vary based on different rates charged for appraisals, attorneys, and even title insurance.
- Closing costs can vary from one lender to another. For example, each lender charges a different application fee. In addition, lenders often charge “points” — so named because they represent a percentage point of the loan amount.
An origination fee is one kind of point. The charge will generally be between 0.5% and 1% of the new mortgage amount. It represents compensation to the lender for placing the loan. Discount points are another type. They represent points paid to lower the mortgage interest rate on a permanent basis.
For example, by paying a discount fee of 1% of the loan amount you have, you can reduce your mortgage interest rate by approximately 1/8 of 1% (0.125%). However, if cash to close is an issue, paying discount points to lower the interest rate isn’t generally recommended. The small decrease in the monthly payment doesn’t usually justify the cost of the discount points paid upfront.
Typical closing costs
Below is a list of common closing costs (other than origination fees and discount points), including their purpose and a general cost range. Not all will be charged in every case, and there may be additional fees specific to your geographic location.
- Application fee — Not all lenders charge this fee, but when they do it usually includes funds for both the appraisal fee and the credit report. It will generally be around 1% of the loan amount if it is charged. (So, $3,600 in our example.)
- Appraisal fee — This is the fee the lender will pay to an independent appraiser to establish the market value of the property you are purchasing or refinancing. It will generally be between $500 and $1,000 depending on the property and appraisal fees in your market area.
- Title search — This is a search done by a title company to determine the existence of any liens against the property. It’s to ensure the property will transfer with a clear title. The cost of the search ranges from $150 to $500.
- Title insurance — You’ll be required to have lender’s title insurance to protect the lender against any undiscovered liens. But it’s strongly recommended that you also get owner’s title insurance, which will protect you if such liens are discovered. The cost of title insurance can range from a few hundred dollars to $2,000, depending on the value of the home.
- Attorney fees — In many states, real estate closings are handled by title companies. But in others, they’re customarily handled by attorneys. Expect to pay $1,000+ depending on the complexity of your transaction and your location.
- Home inspection — While an appraisal will be performed to establish the market value of the home, it does not address deficiencies with the property unless they are obvious. A home inspection is recommended – but not required. The cost will generally be between $300 and $500, but it can be money well-spent if it identifies costly problems that you can have repaired by the seller prior to closing.
- Real estate transfer and mortgage taxes — Many states impose taxes based on the value of the property being transferred or the amount of the mortgage, and sometimes both. It will typically be a small percentage of the property value or the mortgage amount, and will vary by state and county, and sometimes even by municipality.
There are actually two alternatives that can either reduce or completely eliminate closing costs:
- Negotiate for the seller to pay your closing costs – This will only be permissible in areas where this is common practice.
- Negotiate premium pricing with your lender – This is where you pay a higher interest rate on your mortgage in exchange for the lender paying the closing costs.
Either may be a good option, particularly if you are making a minimum down payment, like 5%, and adding closing costs on top would make your cash outlay significantly higher.
Prepaid expenses
These are probably the most confusing charges for home buyers, but they are completely necessary.
With most mortgages, the lender will put real estate taxes and homeowners insurance “in escrow.” This means that those charges will be included in your monthly payment, and paid by the lender when due.
In order for that to happen, the lender needs to collect certain amounts upfront, to ensure that the funds are available. The escrow accounts are set up to pay the charges on the next due date, while a portion of your monthly payment replenishes the escrow account for the due date after that.
- Property taxes — Depending on where you live, and the frequency of real estate tax collections, the lender may have to put anywhere between 2 and 12 months of property taxes in escrow. If the taxes on the house are $250 per month, and a six-month escrow is required, that will translate to a prepaid expense of $1,500 at closing.
- Homeowners insurance premiums— You’re typically required to prepay a one-year homeowners insurance policy on the house, plus an extra two months of premium charges to the lender’s escrow account. The lender may also escrow one or two months of premiums for PMI as well, if required.
Depending on where you live, prepaid expenses may come to as much as 2% of the loan amount.
Fortunately, you can have some or all of the prepaid expenses paid for you by either the seller, or by premium pricing paid to the lender.
A third option is to decline the escrow arrangement by the lender. This will require that you make a down payment of at least 20%.
Utility adjustments
Utility adjustments can include a large number of upfront costs. Luckily, they seldom come to more than a few hundred dollars. They basically represent utility costs paid by the property seller in advance.
For example, if a seller fills the heating oil tank just before the closing, you’ll be required to reimburse the seller for the unused oil. This will happen at the closing table. Similar charges can be incurred if the seller has prepaid other utilities, such as water, sewer, or trash removal.
Still another expense that could require adjustment at closing are homeowners association fees. In many homeowners association neighborhoods, member fees are paid on an annual basis. If the seller has paid the fee for the full year, and you’re closing on the house on March 31 — three months into the year — you will be required to reimburse the seller for nine months’ worth of fees. There may also be a fee to the HOA to get started. They may call it a transfer fee or something similar. Basically, it’s a lump sum upfront from the new homeowner to get into the HOA.
Lender-required “cash reserves”
This one takes many home buyers by surprise. It isn’t a closing expense, but lenders require that you have so much cash left in an emergency fund after all closing costs are paid.
Lenders have a cash reserve requirement to avoid a buyer “closing broke.” They don’t want you to end up in an early-term default. This requirement ensures that you will be able to make your payments during the first few months.
The most typical cash reserve requirement is two months. That means that you must have sufficient reserves to cover your first two months of mortgage payments. So if your principal, interest, taxes, and insurance (PITI) come to $2,000 per month, the reserve requirement will be $4,000.
These are not funds that must be deposited with the lender. But the lender must be able to verify that you will have the funds available in a liquid source. That could be a savings account, checking account, or money market fund. Generally speaking, they frown upon using retirement assets for this purpose, since those funds cannot be easily liquidated.
Increased monthly expenses
When you are looking to buy a house there is a lot more to consider than just meeting the down payment requirements. You’ll want to make sure that you can comfortably afford your new house and the new ongoing expenses.
Remember that your mortgage payment will include more than just your loan amounts. It will also include any property taxes and homeowner’s insurance premiums that are required. When calculating what you can afford be sure to include those costs.
Also, you’ll likely have additional monthly costs such as higher electric bills, higher heating bills, trash, water, etc. Be sure to account for these additional costs when deciding what you can afford.
The bottom line
Many first-time home buyers are surprised to discover the down payment is just one of the home buying costs they’ll have to pay.
For example, if you are buying a home for $400,000 and need a 10% down, you’ll actually need roughly $70,000 in cash to close the sale.
When going through the home buying process, remember to include these additional cash requirements in your homebuying plans. Also ensure that you can comfortably cover your monthly mortgage payments as well as any new expenses that you’ll have in your new home.