When buying a home, loan closing costs can add up to thousands of dollars. To encourage buyers, sellers often offer to contribute money towards these closing costs. But, the government imposes maximum amounts on what a seller can offer. As such, we’ll use this article to explain seller contribution maximums for several common loan types.
Specifically, we’ll discuss the following:
- An Overview of Seller Contributions
- Why Seller Contribution Maximums Exist
- Seller Contribution Maximums by Loan Type
- Using Seller Contributions to Pay the VA Funding Fee
- Final Thoughts
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An Overview of Seller Contributions
While amounts vary by loan type and situation, loan closing costs can add up to 2% to 5% of a loan balance. On a $200,000 loan, this means buyers likely need to pay $4,000 to $10,000 in closing costs – in addition to their down payment. And, buyers often must pay closing costs out of pocket, which can pose a major financial obstacle.
Due to a variety of reasons, sellers may want to help buyers pay these closing costs. If sellers want to quickly sell a home, offering seller contributions can entice a buyer to quickly close on a property. For example, say that a seller needs to use the proceeds from a home sale for the down payment on another home. In this situation, he or she may offer seller contributions to encourage the buyer to close as quickly as possible.
However, it’s important to note that sellers do not need to provide contributions. Rather, this remains a completely negotiable item between sellers and buyers.
Why Seller Contribution Maximums Exist
While sellers can contribute to buyer closing costs, limits exist. That is, with each type of loan, a maximum seller contribution exists, typically expressed as a percentage of the purchase price. These maximums exist for two main reasons.
First, sellers in some markets use these contributions as a competitive tool. And, in extreme cases, large concessions could entice borrowers to request home mortgages larger than they can actually afford. In other words, large concessions may disguise a buyer’s inability to qualify for a loan.
Second, excessive concessions can distort property values in an area, making home buying more difficult for everyone. As a result, regulators like Freddie Mac, Fannie Mae, and HUD impose regulations to keep home values sustainable. For example, say you want to buy a home worth $200,000. The owner wants to sell quickly so offers a $20,000 contribution towards closing costs and says you can keep anything extra. But, to do this, he changes the home price to $220,000 and bribes the appraiser to declare a $220,000 value (an unfortunately realistic scenario). Accordingly, the following occur:
- You pay more than the home is worth.
- Comparable homes in the neighborhood will start selling for $220,000, as well, making buying a home more unaffordable for everyone.
- The bank loan does not reflect the true home value.
If this cycle continues, home values and loan amounts will quickly reach unrealistic levels. And, if a broader economic shock leads to high default levels, banks and mortgage investors take a tremendous hit. Seller contribution maximums exist to prevent such a negative outcome.
Seller Contribution Maximums by Loan Type
VA Loans
The VA makes a distinction between total seller contributions and seller concessions. Concessions represent all payments made by sellers above ordinary loan closing costs. While not a comprehensive list, here are some common seller concessions:
- Payment of the VA funding fee
- Property tax and insurance prepayments
- Gifts such as appliances (e.g. TVs, microwaves, etc.)
- Payment of extra mortgage points for permanent interest rate buydowns
- Payoff of credit balances or judgments on behalf of the buyer
According to the VA, sellers cannot offer concessions greater than 4% of the home’s appraised value. But, no limit exists on seller contributions towards ordinary closing costs. For instance, say a seller offers to pay 3% of the purchase price towards closing costs and 2% towards the VA funding fee. The total seller contribution equals 5%, but it’s allowed because the 3% towards closing costs does not count towards the 4% limit on seller concessions.
FHA Loans
Unlike the VA, the FHA doesn’t differentiate between seller concessions and total contributions. Rather, with FHA loans, sellers can contribute up to 6% of the sales price towards any of the following:
- Closing costs
- Prepaid expenses
- Discount points
- Any other financing concessions
Conventional Loans
Seller contributions on conventional loans prove more convoluted than with either VA or FHA loans. Fannie Mae and Freddie Mac regulate conventional loans, and they set contribution limits depending on A) property type, and B) down payment size:
- Property Type / Down Payment / Seller Contribution Maximum
- Primary or second home / less than 10% / 3%
- Primary or second home / 10% – 25% / 6%
- Primary or second home / 25% or more / 9%
- Investment property / any amount / 2%
Technically, seller contribution maximums exist with conventional loans. But, these limits are extremely generous – more than most sellers will contribute – meaning that these maximums rarely factor into a deal.
Using Seller Contributions to Pay the VA Funding Fee
For veterans, active troops, and other eligible borrowers, the VA funding fee adds a significant amount to the cost of a VA loan. Depending on the borrower’s situation, this funding fee ranges from 1.4% to 3.6% of the loan balance. On a $300,000 loan, that’s $4,200 to $10,800 above ordinary closing costs. Yes, you can often roll this into the loan balance, but that still means you have to pay it over time.
With the VA’s system, sellers cannot provide concessions greater than 4% of the home’s appraised value. Ordinary closing costs do not count towards this ceiling – but paying the buyer’s VA funding fee does. As a result, if you find a particularly motivated seller, you can negotiate for him or her to pay all of your closing costs and your VA funding fee, as the 3.6% maximum VA funding fee does not exceed the VA’s 4% ceiling on seller concessions. If able to find this sort of deal, you could potentially close on a VA loan with zero out-of-pocket expenses, as the seller’s total contributions would cover everything.
Final Thoughts
Regulators impose seller contribution maximums to protect both A) the borrower, and B) the broader housing market and economy. But, if you understand how these seller maximums work, you can potentially negotiate thousands of dollars in closing cost savings. And, for VA loan borrowers, recognizing the difference between seller concessions and total seller contributions can save you even more money at closing.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
