What Are the Disadvantages of a Seller Paying Closing Costs?
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Summary:
There are good reasons why a seller might want to pay for the closing costs of a real estate transaction, such as if the area is in a buyer’s market or the owner of the property is highly motivated to sell. But there are also disadvantages of the seller paying closing costs that both the buyer and the seller should be aware of.
A real estate transaction is no simple process. Nor is it cheap, even when you’re the one selling the property and, theoretically, expecting to make a profit on the deal. In fact, it’s usually even more costly to sell a house than it is to buy one, at least when it comes to closing costs. Closing costs are all the various fees, charges, and commissions that buyers and sellers have to pay on the closing date of the home-buying process.
Today we’ll take a look at the advantages and disadvantages of a seller paying closing costs from the perspective of both the buyer and the seller. Let’s start by taking a look at why a seller would be willing to pay the buyer’s closing costs in the first place and how they structure it.
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Disadvantages of seller paying closing costs
If you’re the seller paying closing costs on behalf of the buyer, make sure you understand all of the risks beforehand.
Issues with appraised value
Before proceeding with any home sale, the property must be appraised. So if a seller raises the asking price of a home to cover closing costs, this might become a problem after the home appraisal. Most mortgage lenders won’t finance a loan amount that’s larger than the appraised value because they risk not getting their money back if the buyer defaults on the mortgage.
In the event that the appraisal is higher than the mortgage amount, the lender will typically ask the buyer to close that gap by putting up the difference. If the buyer can’t manage that, which is highly possible, then they may need to back out of the deal, leaving the seller to come up with a new buyer.
Higher overall closing costs
When a seller offers to pay the closing costs for potential buyers outright, rather than just getting a higher price for the home, they have to come up with a lot more cash upfront. For example, let’s imagine the asking price is $300,000 and that closing costs are on the lower end. In this case, we’ll say the seller’s costs are 6% and the buyer’s are 2% for a total of 8% in closing costs.
Overall, that means the seller is on the hook for $24,000, which includes $18,000 on the seller’s side and $6,000 for the buyer. In a more competitive market, a seller could save themselves (at least) $6,000 for not covering the buyer’s closing costs.
Fraud potential
A further disadvantage of the seller paying closing costs is the federal limitations on seller concessions, also known as interested party contributions (IPCs) by Fannie Mae and Freddie Mac. These concession limits apply not only to the seller but also to a builder, developer, or real estate agent. The regulations are in place partly because it’s believed that excessive concessions can lead to artificially inflated housing prices.
This means if a seller or other interested party tries to exceed the limitations on concessions by going outside the boundaries, it’s considered grounds for fraud. For example, a seller can’t just give the buyer money “under the table” to make the deal go through. The concessions must be disclosed.
Loan regulations on concession limits
Both the buyer and seller need to be aware of federal loan regulations, which restrict how much seller concessions can be offered. Depending on the loan type and loan-to-value ratio (LTV), these limitations are between 2% and 9% of the purchase price.
This means that a seller may not legally be allowed to pay a buyer’s total closing costs and can only cover a portion of them. For example, conventional loans cap seller concessions at 3% of the sales price when the LTV is more than 90% (meaning the down payment is 10% or less), but go up as the LTV drops.
What is LTV?
Loan-to-value (LTV) is a financial ratio used by lenders to determine the risk of a loan. It represents the relationship between the amount of the loan and the appraised value of the property that will secure the loan. Lenders use the LTV ratio to assess the level of risk they face in granting a loan.For example, if a property is appraised at $200,000 and a borrower is applying for a loan of $160,000, then the LTV ratio would be 80% ($160,000 ÷ $200,000). A higher LTV ratio means a borrower is taking on a larger amount of debt in relation to the value of the property. A lower LTV ratio, on the other hand, means that the borrower is borrowing less in relation to the value of the property.
Furthermore, “On an FHA loan you can cover up to 6% in closing costs and on a VA loan you can cover up to 4%,” adds Robert Levi Thompson, Realtor at Allison James Estates and Homes.
| Loan Type | LTV | % of Purchase Price |
|---|---|---|
| Conventional loan (primary residence or second home) | Greater than 90% | 3% |
| 75.01% to 90% | 6% | |
| 75% or less | 9% | |
| Conventional loan (investment property) | N/A | 2% |
| FHA loan | N/A | 6% |
| VA loan | N/A | 4% |
Disadvantages for the buyer when the seller agrees to cover closing costs
On the surface, it might seem like the seller paying closing costs for the buyer is an ideal situation. The biggest benefit is that potential buyers can save money upfront since they don’t have to bring thousands of dollars to the table. This can leave them with extra money to get set up in their new home. But there are some potential drawbacks to consider.
Obtaining mortgage approval
This is a disadvantage as much (if not more) for buyers as it is for the seller. As explained earlier, if the home appraisal is more than the loan amount, the mortgage lender will either ask the buyer to kick in the difference or reject the loan application.
If you do pay the difference between the appraisal and the loan offer, it effectively negates the benefit of the seller paying closing costs. If you don’t pay, the deal will fall through and you’ll need to start all over with another house.
Higher mortgage and mortgage payments
If you’ve opted to roll the closing costs into the mortgage rather than taking seller concessions at closing time, you’ll wind up with a bigger mortgage and pay more interest than the initial sales price implied. This also means you’ll have a higher monthly payment than you may have originally budgeted for.
Neither of these issues may be of much concern to you — after all, a few thousand dollars more on a 30-year mortgage may not be that significant for some households. However, it’s still something to be aware of and think about when you’re in the midst of the negotiation process.
Bigger down payment
A larger purchase price will also come with a bigger down payment. Down payments are calculated based on a percentage of the sales price, and most people like to put down at least 20% to avoid paying private mortgage insurance (PMI).
Let’s say you originally planned on putting down 20% on a $300,000 house, or $60,000. Instead, the seller rolled your closing costs into the mortgage, so now you’re paying $310,000 for the house. This means you’ll need to come up with another $2,000 if you want to avoid PMI.
Overall, if a seller offers to cover closing costs, make sure you get those seller concessions at the time of closing. This is usually a much better deal for a buyer rather than paying a higher sales price.
Pro Tip
To avoid any confusion at the closing, be sure the purchase agreement specifically spells out the seller contributions. It should state either an exact dollar amount or a percentage of the total purchase price.
Why would a seller pay closing costs?
On average, closing costs for the seller are between 6% to 10% of the purchase price of the home. By contrast, the buyer’s closing fees usually come to about 2% to 5% of the purchase price.
Since seller closing costs are typically much higher than buyer closing costs, you might be wondering why a seller would willingly offer to pay closing costs for the buyer, too. However, there are a few reasons why it might make sense.
It’s a buyer’s market
A buyer’s market occurs when there are too many houses on the market and not enough buyers to purchase them. This means that sellers are competing for a smaller pool of buyers, so if they want to sell within a reasonable period of time, they might need a way to stand out from the competition. (For reference, a seller’s market is the exact opposite — there are not enough homes and too many buyers.)
Sometimes, a seller will choose to lower the asking price of the home to attract additional buyers. In other cases, they might offer to pay the buyer’s closing costs, otherwise known as seller concessions. As a result, the home purchase is made that much more attractive for the buyer because they don’t have to come up with a few thousand extra dollars at the closing table.
Pro Tip
Know the status of the housing market. When in doubt, ask your real estate agent whether now is a good time to offer seller concessions to sweeten the deal. If it’s currently a seller’s market, there’s almost no good reason to pay the buyer’s closing fees.
Highly-motivated seller
In other cases, a seller may be in a hurry to sell their house, regardless of what’s going on in the market. For example, the purchase of a new home may be contingent on the sale of this house. Or maybe the seller is moving abroad and doesn’t want to leave any loose ends dangling.
In any event, if a seller wants to speed up the sale of the home, they may offer to cover the closing fees for the buyer in order to sell the property that much quicker.
To attract more buyers
In many cases, people who are looking to buy a home have managed to save up enough for a down payment. Unfortunately, they may not have accounted for the extra funds they need for buyer closing costs. If sellers pay closing costs instead, then they open themselves up to an expanded market of buyers, which makes them more competitive against other sellers.
For these buyers, lowering the price does not help. It's a cash-to-close issue. They may have the down payment but not the closing costs which can often be higher than the required down payment. Sellers' paying closing costs becomes a very good way to open their home to more buyers and more offers. -- Kristen Conti, Owner-Broker at Peacock Premier Properties. Click to Tweet
Ways for sellers to cover closing costs
There are basically two ways in which a seller pays closing costs for the buyer: They either charge a higher sales price or offer seller concessions at the time of closing. Either scenario lowers the amount of cash buyers have to bring to the closing table.
Charge a higher purchase price
Let’s say a homeowner wants to list their house for $300,000. Instead, they agree to cover the buyer’s closing costs in exchange for the buyer agreeing to a sales price of $310,000. In this case, you’re effectively rolling the closing costs into the mortgage loan, avoiding additional out-of-pocket costs for both the buyer and seller.
“Most buyers don’t have a lot of cash available and would rather pay a higher mortgage. Remember, a few thousand dollars difference will not make a big difference on a mortgage payment,” says Thompson. “In most cases, you can raise the price of the house to cover the closing cost. That way the net to seller stays the same.”
If you find yourself in this situation, make sure your mortgage loan is big enough to cover the additional costs. To get a better idea of what this could cost you in the long run, take a look at some of the mortgage lenders below.
Pay buyer’s closing costs out of pocket
Another option — particularly to avoid raising the asking price (which has its own set of problems) — is to offer seller concessions at the time of closing. This means literally the seller pays the buyer’s closing costs out of pocket in addition to their own.
This is obviously a more expensive option for the seller, which will also cut into their profit margin. However, it might make sense in a buyer’s market or if the house hasn’t had a reasonable bid in months.
FAQs
What are the most common closing costs?
Closing costs vary from buyer to seller (and state to state). However, these costs often include attorney fees, recording fees, real estate commissions, transfer taxes, origination fees, property taxes, escrow fees, and title insurance.
What should a seller do before the final walk-through?
To avoid having to cough up any extra cash or do any further work on the home, the seller should do a final walk-through of the property before the buyer does theirs. Your checklist should include making sure the place is clean, all the required repairs are complete, and there’s nothing left in the garage, basement, attic, etc. In addition, don’t remove anything that’s attached to the house unless you explicitly stated you were going to keep it.
What should a buyer do at the final walk-through?
The buyer’s final walk-through usually happens just before closing or even on the morning of the closing date. This is typically your last chance to notice anything wrong, so give it a thorough once-over.
That means flushing the toilets and checking all the faucets; testing all the light switches, outlets, and appliances; verifying all repairs were made; and making sure that everything was left that was agreed upon in the contract.
Key Takeaways
- While a seller can offer to pay all of the closing costs on a home sale, there are disadvantages for both the buyer and seller.
- On the seller’s end, paying additional closing costs may result in issues with the appraised value of the home, increased closing costs, and risk of fraudulent activity.
- On the other hand, disadvantages for the buyer include the potential for a higher purchase price, resulting in bigger mortgage payments and a larger down payment.
- Paying a buyer’s closing costs typically takes two forms: Asking for a higher purchase price or offering seller concessions at the time of closing.
- Conventional loans, FHA loans, and VA loans all have limits on seller concessions that buyers and sellers need to be aware of to avoid possible fraud.
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