Jun012009

How much cash do you really need to buy a house?

Unlike the heyday of the Great Housing Bubble when 100% financing was readily available, it now takes cash to close a real estate deal. If you have no cash, you get no house.

So how much cash does it take to close a deal? and how much cash do you need to have available to get through the process and still have a life? The actual cash demands during the process come from four main areas:OCHN_good_news

  1. Downpayment — 3.5% – 20%+
  2. Closing Costs — 1% – 3%
  3. Inpsection Contingencies — 0% – 5%+
  4. Furnishing and Move In — 2% – 5%+

The down payment is the largest and most obvious use of cash in the homebuying process. Down payments are generally 20% of the purchase price of the home because lenders are usually only willing to loan 80% of the appraised value or purchase price, whichever is smaller. Lenders will extend loans at levels greater than 80% of the value if a third-party issues insurance on the loan and promises to pay off the lender in the event of a loss.

The insurance on loans can come from a government entity like the FHA, or it can come from a private mortgage insurance company. In the wake of the Great Housing Bubble, private mortgage insurance is very hard to obtain due to excessive losses by insurers. The only insurer of loans over 80% LTV is the FHA which insures loans up to 96.5% LTV; this results in a 3.5% down payment. The problem with FHA loans, and all private mortgage insurance, is the cost; you pay a premium for this insurance that comes out of the amount you could be putting toward a larger payment on a larger loan. Basically, if you don’t have a 20% down payment, you will get much less house because you will both finance less and have less to put down.

Another issue related to down payments is caused by a low appraisal. Sometimes buyers fall in love with a property and bid higher than its appraised market value (this also happens with falling comps in a declining market like ours today). When an appraisal comes in below the agreed sales price, the lender will only loan to appraised value–the buyer must make up any shortfall with their own cash if they want to close the deal. This is one of the reasons down payments have been so high in Irvine since prices started falling; only those with the extra cash can close the deal.

Closing costs are another hefty yet forgotten drain of your cash. These come in two forms; fees and contingencies. The fees you will pay may include any of the following: appraisal fees, lender fees, assumption fees, attorney’s fees, credit report, escrow company fees, “garbage” fees (miscellaneous charges, not your garbage pick up), loan fees, inspection reports (more on this next), prepaid homeowners insurance, prepaid loan interest, prepaid property taxes, private mortgage insurance, recording and filing fees, survey fees, tax service fees, title search fees, transfer tax, and other fees. Not all of these fees are incurred on each transaction, but most are. These add up to between 1% to 3% of the purchase price of the property with 2% being the norm. Buyers pay this out of their cash as these costs are not usually rolled up into the loan.

Once you enter the escrow process, you will pay for property inspections (you do not have to, but you are very foolish not to). The inspections may turn up expensive repairs. Some repairs may be immediately necessary while some may be able to be deferred. In either case, you will need to go back to the seller to negotiate who will pay for these repairs. The seller is under no obligation to offer you any allowance or offer to make repairs to the property. If the seller is unwilling to make repairs, as a buyer you have the right to terminate the escrow and obtain a refund of your deposit, or you can decide to go ahead with the deal and make the repairs yourself–out of your own cash. It is sometimes possible to get the loan increased to cover these items, but usually it is not.

The cost of moving in and furnishing the property is another area of cash need. Many people simply move the furnishings from their previous residence, but many do not. It is a nearly universal desire to have new furniture and appliances when moving in to a different house. Those that have the cash reserves after the closing nearly always do this. Depending on the tastes of the owners, this number can be just about anything, but a good rule of thumb is to have 2%-5% of the purchase price set aside for moving expenses and new furnishing.

Another issue related to cash management and housing costs is the need to keep a cash reserve. Financial planners tell people they should have six months cash reserve as liquid savings at all time. Although that sounds good in theory, in practice almost nobody does this. In the real world few people consider all the expenses listed above, so they drain every penny they have by the time they close escrow; the cost of furnishing and moving in is financed on credit cards. The closest most people have to six months reserves is a large available credit line through a collection of credit cards. Lenders often require borrowers prove they have at least two or three months of mortgage payments saved up, but even if they had this at closing, most blow it when they move in.

Despite these real world problems, it is important to have an adequate budget for the actual cash demands of the transaction and the move in plus the cash reserves to survive after the fact. During the housing bubble, people could rely on house price appreciation to furnish the house, fund all repairs, replenish an emergency reserve fund and provide additional spending money. Over the next decade or more, houses will provide none of these things; the money will need to come out of wage income. Few are prepared for this reality, but now you know what you are facing and how much this will all cost. Think about it when you go to bid on property when the time is right.