Ask the Underwriter is a regular column for HousingWire's new LendingLife newsletter, addressing real questions asked to, and answered by, professional mortgage underwriter, Dani Hernandez. Read past articles by clicking here.
“Dani! The Closer just emailed me saying the closing costs paid by the seller needs to be reduced from $5,000 to $0, because after adding in the Seller Tax Credit, the cash due at closing from the borrower is less than the FHA Minimum Required Investment of 3.5%! We’re going to need an addendum to the sales contract signed, the appraisal will need to be updated, and this is going to delay the closing tomorrow!”
Ask any mortgage professional and they will tell you if you use an FHA loan to buy a new home, you must make a Minimum Required Investment (MRI) equal to 3.5% of the purchase price or appraised home value (whichever is less). Most of these “experts” will also tell you this means the minimum down payment and cash due from the borrower at closing must be equal to 3.5%, and they will insist your out-of-pocket cost cannot be any less. And this misconception is so widely believed that it caused a bit of panic in my office this week.
You see, there is this little loophole in the FHA guidelines. The loophole allows borrowers who live in a state where property taxes are paid in arrears to meet the Minimum Required Investment with money paid by the seller! In this week’s article, I’m going to tell you a true story about how we saved our borrowers thousands of dollars by simply applying the guidelines correctly and explain how you can do the same.
The Problem
Our borrowers were purchasing a new home for $200,000 using an FHA loan, and the closing was scheduled for Friday morning. In the sales contract, the buyer and seller had agreed the seller would pay for $5,000 of the closing costs due from the buyer. When the Initial Closing Disclosure went out earlier in the week, the closing costs and prepaid items were $16,000. After subtracting the $5,000 to be paid by the seller, the cash due from the borrower at closing was estimated to be $11,000 – the cash to close was $4,000 over the Minimum Required Investment of $7,000 (3.5% of the purchase price).
On Thursday, behind the scenes, the title company and closer were working with the real estate agents and attorneys to finalize the numbers and prepare the closing documents. Everything was on track until the amount for the Seller’s Tax Credit was received from the seller’s attorney… $9,000. Essentially, this credit reduces the amount of money due from the borrowers at closing, $11,000 – $9,000 = $2,000. The MRI for this loan is $7,000, but the borrowers are only paying $2,000 at closing to purchase this home! And this is when everyone started freaking out…
Wait, what is a Seller Tax Credit?
In some states, like Illinois, property taxes are paid in arrears. I’m sure you’re wondering, “What does that even mean?!”
Think of property taxes as charges due for services performed by the government. The services get provided from January 1 to December 31. The charges (property taxes) for the current year accumulate over a 12-month billing period, and you pay the charges next year… All of the charges for 2017 are not billed until 2018.
Now, if you bought a house on December 1, 2017, it wouldn't be fair if you got a bill in 2018 and had to pay for the services provided to the seller from January 1, 2017 – November 30, 2017. The seller should have to pay for the charges that accumulated before you bought the house… This is why the Seller’s Tax Credit was created! The seller pays the buyer for his share of the charges in the form of a Seller’s Tax Credit at closing. When you pay the bill in 2018, you don’t feel like you’ve been had, because you collected the seller’s portion of the bill back in December!
The Solution (from someone who is not the underwriter)?
Everyone was freaking out because the borrower was only paying $2,000 at closing to purchase the home, and FHA says they needed to pay a minimum of $7,000 to meet the MRI. The closer decided the only way for the borrowers to meet the MRI would be for them to give back the entire $5,000 the seller had agreed to pay towards their closing costs ($2,000 + $5,000 = $7,000). If you were the buyer, I’m guessing you would be less than thrilled about losing $5,000, and I bet you’d like to be the person giving them this news, even less… which is why our team lead decided to #asktheunderwriter *winky face* for help.
The (Real) Solution
DO NOTHING AND LEAVE EVERYTHING AS IS!
I know what you’re thinking – “WHOA! But what about the 3.5% Minimum Required Investment?!”
The Loophole
According to the FHA Guidelines from HUD:
“Where real estate taxes are paid in arrears, the seller’s real estate tax credit may be used to meet the Borrower’s Minimum Required Investment, if the mortgagee documents that the borrower had sufficient assets to meet the MRI and the borrower paid closing costs at the time of underwriting. This permits the borrower to bring a portion of their MRI to the closing and combine that portion with the real estate tax credit for their total MRI.”
Translated into English, this means if you live in a state where property taxes are paid in arrears, the Tax Credit received from the seller is counted as part of the Minimum Required Investment! You will still need to verify that you have enough money in the bank to pay for the MRI plus the closing costs, but if the Seller Tax Credit equals 3.5% of the purchase price, you do not have to pay any part of the MRI from your own funds… just leave all that money in the bank. And, if the amount you have agreed for the seller to pay part of your closing costs (the maximum allowed is 6% of the purchase price in most situations) plus the Seller’s Tax Credit is more than or equal to the total closing costs and prepaids…you can purchase a home without paying anything out of pocket!
So, the next time someone tells you that you need to pay the 3.5% FHA Minimum Required Investment using your own funds… tell them you know about a loophole in the guidelines and they can check it out HERE!
