The Hidden Costs of "Closing Costs"

As an agent I can see firsthand the reality that most Americans have no savings. Even in affluent sections of Washington, DC I have clients with very strong incomes but no savings. This becomes an issue when it’s time to buy a home because saving up for a down payment is hard enough; but when buyers find out they need an additional 3% for “closing costs” there is despair in my buyers’ eyes.

Suppose there is a home for sale for $500,000 and the buyers need to put 3.5% down to buy the house, the buyers would need $17,500. (Realistically, an FHA 3.5% down loan is the cheapest possible option most buyers can hope for.) In addition, the buyers need $15,000 for the closing costs. Thus, the buyer needs $32,500 in order to buy the home. 

It may take buyers years to save the initial $17,500 down payment to say nothing of the additional $15,000 for the closing costs.  How can a buyer save years of additional scrimping and buy as soon as possible? The glib advice handed out by “housing experts” in the local and national papers is to simply ask the seller to “pay the buyer’s closing costs.” This is referred to as a “Closing Cost Credit” or a “Seller Subsidy.” What it means practically is that the buyer is building their closing costs into their mortgage.

Here’s how it works:

The buyer offers to buy the $500,000 home for $515,000 and asks the seller to “give back” $15,000. The seller will “NET” $500,000 from the sale ($515,000 - $15,000 = $500,000 NET Price). The buyer would only need a down payment of $18,025 to buy the home; and the $15,000 “give back” is used to pay for the closing costs.

This scenario seems like a win-win. The seller gets the NET price he wants and the buyers get the house with only $18,025 in cash instead of $32,500. Frequently this is a win-win deal, but there are some considerations that most buyers and sellers don’t think about.

For a Buyer, there are four major concerns:
There is no such thing as free money. The $15,000 “give back” is not really a concession at all. It’s simply a contrivance to allow the buyers to finance the closing costs. Even at a 4% interest rate this will cost the buyers $10,780 over 30 years.

The buyer has to pay closing costs on the $15,000 which means that the buyer is paying an additional $450 in closing costs by financing them. That’s not a large sum, but it’s a hidden cost often forgotten.

The buyers must be certain not to ask for too much in closing costs. If the actual costs end up being less than the subsidy the seller may have the right to keep the differential! This can be a big surprise for an unprepared buyer.

The buyer must be certain the bank will allow the seller subsidy at all. Sometimes the particular loan type prohibits seller subsidies or limits the maximum possible subsidy. Additionally, as a transaction progresses it is common for buyers to ask for seller subsidies in lieu of the seller making repairs to a home. It’s important not to ask for too much in subsidy because the bank may not allow the increased subsidy or may even reject the loan.

For a Seller there are three major concerns:
The commissions paid to agents is based on the Sales Price not the NET Price. That means that the seller is paying commissions on money he doesn’t receive. On a $500,000 this can be $900.

Just like the buyer, the closing costs are based on the Sales Price. That means the seller is paying closing costs on money he does not receive. This is usually an additional $300. 

These first two costs added together mean the $500,000 NET the seller is expecting is actually $499,100. Usually sellers don't realize this until settlement and by then it's too late.

The property has to appraise for the higher price. In these days of tightened lending this can be an issue. If the home does not appraise for the Sales Price the buyer will (in most circumstances) have the option to renegotiate the price to a lower value or walk away. This can be particularly galling for a seller when a home appraises for more than the NET Price but less than the Sales Price and the seller’s proceeds are reduced.

Conclusion:
None of the issues with closing costs are insurmountable and frequently subsidies are the only way to make a sale happen. But it’s important that both buyers and sellers know what the pitfalls are before committing to a subsidy in a transaction. Be certain to discuss these details with your agent before signing a contract.

DC House Market Still Strong, But Plateauing

The real estate market for houses in Washington DC remains strong, but there are possible indications of a coming plateau in the market.

Inventory of available houses in Washington is down 27.3% in April 2012 vs. 2011 (1,199 vs. 872). This is, obviously, an indication that the marketplace is recovering from the downturn. It’s important to note that at this point, inventory is down 46.5% from the highest level of inventory in 2008 when there were 1,835 houses on the market.

One small indicator that the market is slowing slightly is that the total number of new listings on the market for April is “only” down 16.5% versus last year (505 vs. 605). While that’s still very good news, it’s 10.8% higher than the drop for the rest of 2012. This indicates that the dearth of inventory is lessening.

Another gray cloud is the number of contracts taken. For the year so far, contracts for houses in Washington, DC are down 2.5% compared to last year (1,407 vs. 1,443). While that is a very small increase and is also related to a lack of inventory to buy it’s an indication that buyers are not willing to just buy anything at any price.

Slightly more troubling than a drop of 2.5% of contracts year over year is that the number of contracts taken in the month of April is down 3.7% compared to last year (445 vs. 462). This indicates that the slowdown is accelerating.

Clearly, the overall news is about sales of houses in Washington, DC is very good and we are still in a slight seller’s market. But, the combination of the drop of inventory slowing and the number of contracts slowing indicates that the market for houses in Washington, DC is not accelerating, but may well plateau in the near future.

What this means for a seller is that it’s important not to overestimate your position in negotiations. It’s still crucial to price your home aggressively (meaning on the lower end of a range of possible prices) and be prepared for a market that is slowing, not accelerating. From a buyer’s point of view this market data is an indication that the market is still slightly in the seller’s favor, but it’s not surging towards a full-blown seller’s market. Buyers need to bring strong offers for homes that are well priced and expect to compete when a home is intentionally priced below market.

Here is a link to the statistics from the Greater Capital Area Association of Realtors: http://www.bestaddress.com/upload/documents/dcsf041212052313195438866.pdf  These were the statistics that were used for the information in this blog posting.