As much as I have talked about the difference between these two things, I was surprised to see I hadn’t written about it because it can make a huge difference, sometimes make or break, with regard to a borrower’s situation relative to the money needed for closing costs.
The Scenario:
Let’s take a look at a generic scenario and then run the numbers to see which way is going to be the best option financially speaking. We’ll assume a purchase price of $400,000 and a down payment of 20%. Assume that either the inspection or the appraisal reveals some repairs that should be made and let’s say those repairs are $5,000. To the seller, it makes no difference whether they decrease the price by $5,000 or pay a credit for $5,000 – it is exactly the same either way. To the buyer, the difference can be huge. The same concepts apply when a buyer is contemplating whether to offer $5,000 less or to have the seller pay $5,000 in closing costs.
Here Are the Numbers:
If the purchase price is reduced by $5,000 to $395,000, the down payment will be $79,000 with a loan amount of $316,000. The down payment in this scenario is only $1,000 less than the full-price offer of $400,000 with an $80,000 down payment where both down payments are 20%. While the purchase price is $5,000 less at $395,000 vs. $400,000, the borrower is really only saving $1,000 in terms of money out of pocket to close. The loan will be $4,000 less with the $395,000 purchase price so the monthly payment at a 3% interest rate would yield a monthly payment savings of $16.86 which is $6,069.60 over a 30 year mortgage. The fact is that very few people keep a mortgage for more than 10 years, let alone a full 30 years. After 10 years, the payment savings would be $2,023.20, just over half of the money the borrower had to pay in extra down payment.
With a purchase price of $400,000, a loan amount of $320,000, and a credit towards closing costs of $5,000 from the seller, the borrower’s payment will be $16. 86 more than with the smaller loan but s/he will keep $4,000 more in his/her pocket than with the lower sales price option. The down payment is $1,000 more but s/he pays $5,000 less in closing costs for a net gain of $4,000. Without considering the time value of money and thus giving now value at all to the $4,000, the borrower would have to keep the loan for 237.247 months ($4,000/$16.86) before the payment savings on the smaller mortgage overtakes the $4,000 saved by going with a lender credit and a higher purchase price. However, money does have value and with $4,000 the borrower didn’t have to pay toward closing costs, the money can be invested (it could also be used to pay for renovations or furniture, both of which have value – at the very least, it’s saving a lot in interest that might otherwise be paid on a credit card). If we assume a very conservative rate of return of 8%, $4,000 becomes $8,635 after 10 years and $18,643 after 20 years. If that money is invested in mutual funds like the ones I invest in that average over 15% annually for 10+ years, the investment value is much higher: $65,466 or more after 20 years.
For many borrowers, coming up with money for the down payment and closing costs is a challenge and having an extra $4,000 to work with can be the difference between getting the deal done and having to move on to a different home. The state of the market will often dictate whether sellers will be willing to pay for closing costs but in scenarios where they may have to pay for repairs and the choice is between lowering the price and a closing cost credit (assuming the repairs aren’t required to be fixed and verified before the close), the credit makes more financial sense (and cents, or dollars).
The Bottom Line:
How you structure your loan matters and can make a huge difference in your financial situation. Just a small difference of $4,000 on a purchase price of $400,000 can make a huge difference – just think how big the difference would be with an even bigger amount such as when somebody is contemplating putting down 30%-50% vs. 20% and investing the rest (http://thewunderliteam.com/money-in-your-house-vs-money-invested/ ) – the numbers get really large under scenarios like this. If you have any questions about the concepts in this post or you would like run the numbers for your situation, feel free to contact me on my cell at 702-812-1214 or via email at jwunderli@gmail.com.
