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Cash Back at Closing Q&A

Written by Posted On Thursday, 21 February 2008 16:00

Leading up to the current mortgage meltdown, one of the most common forms of real estate and mortgage fraud being perpetrated was cash back at closing. Unfortunately, even after we have witnessed the fallout from bad loans, cash back at closing continues to be a problem. Many people, even real estate professionals, consider it to be at its very worst a victimless crime. They see nothing wrong with it.

In order to address the problem, we must first realize what we are dealing with. In this Cash Back at Closing Q&A, I answer the two most basic questions about cash back at closing: What is it? and Why is it wrong? I then go on to answer several of the most common questions I hear from consumers and real estate professionals. In these answers I explore some of the subtleties and gray areas where consumers and professionals often become confused.

Question: What is cash back at closing?

Answer: Cash back at closing occurs when a buyer agrees to pay more for a property than its true market value, so he or she can borrow more money than the home is worth and receive the excess proceeds in the form of cash, credit, or something else of value when the transaction is completed (closed).

A common myth is that as long as the lender's appraiser approved the sale amount, it's okay. The truth, however, is that the value of a house is whatever a buyer is willing to pay for it and the seller is willing to accept for it or the appraised value (whichever is lower). For example, if the seller is willing to sell their property for $250,000 to a buyer who agrees to pay that amount, the buyer and seller cannot agree to put the deal together at $325,000, even if an appraiser sets the home's value at that amount.

Question: Why is cash back at closing wrong?

Answer: Cash back at closing is wrong for many reasons, including the following:

  • It fools the lender into approving a mortgage loan in excess of the property's true market value. If the borrower defaults on the loan, the value of the collateral (the home in this case), would be insufficient to cover the debt.

  • Cash back deals place the borrower in a negative equity situation. If the person experiences a financial setback, he or she has no equity safety net; that is, the person is less able to refinance out of trouble using the equity in the home.

  • Property values are inflated making housing less affordable.

  • Property taxes, which are calculated on property values, also become inflated.

  • Housing markets become unstable as housing bubbles form as a result of artificially inflated prices.

Note: Cash back at closing constitutes lying to the lender, something that is strictly prohibited on the Uniform Residential Loan Application or 1003 (ten-o-three) that every homebuyer/borrower must sign when applying for a mortgage loan. The 1003, which is authorized by Title 18 of the United States Code, Section 1001, is very clear in this regard. To paraphrase, you cannot lie on a loan application or any other document related to a transaction. When a buyer, appraiser, real estate agent, loan officer, or another party provides a false statement of a property's value on a 1003 or any other document related to the mortgage loan, they have lied, which means they have also broken the law.

Question: Is it ever legal for the buyer/borrower to receive cash back at closing?

Answer: When I write about cash back at closing, I am primarily talking about cases in which the lender is being duped into approving a mortgage loan for more money than the property is worth so the buyer/borrower can receive a cash profit when the deal closes. I am not writing about instances in which a seller, for example, hands the buyer a couple hundred dollars to cover the cost of repairing a few minor defects that were discovered between the signing of the purchase agreement and closing.

There are several cases in which it may be okay for the buyer/borrower to receive cash back at closing, such as the following:

  • You refinance your mortgage to cash out some or all of the equity in your home.

  • Your agent agrees to refund a portion of his or her commission at closing, a practice I would never recommend. This is a very gray area. Some lenders allow it and some do not, so if you (as an agent) choose to do this, make sure you fully disclose it to the lender on the HUD-1 as a debit to the selling agent's commission and a credit to the buyer. This also must be reported to the IRS.

A better way to handle situations like this may be for the agent to reduce the amount of his or her commission during the negotiation of the sale, so that no money needs to be transferred at closing. According to most CPAs I have talked to, this "credit" actually needs to be recorded as a reduction of their basis in the sales price. For example, if the buyer purchased the property for $300,000 but paid only $290,000 with the reduced commission, then the official sales price is $290,000. In any event, full disclosure is a must, and all parties involved in the transaction must agree to the terms.

  • The buyer makes a deposit into the escrow fund, obtains a 100% loan, and then receives a credit back. This isn't considered cash back at closing, because it is the buyer's own money.

  • When seller is assisting buyer with down payment and closing costs, earnest money can often be returned at closing.

  • When buying an income property, if rents accrued and deposits equal more than the down payment and closing costs (perhaps with seller assisting with a portion or all of either or both), then those sums can often be given to the buyer at closing.

Note: In none of these instances is the buyer/borrower being paid proceeds from the mortgage loan that he or she secured to purchase the property, so these instances fall outside the scope of how I define "cash back at closing."

Question: Can the seller pay the buyer cash back at closing to cover repairs to the property?

Answer: If a minor defect is discovered between the time when the purchase agreement is signed and the closing or final walkthrough, then it's perfectly okay for the seller to reimburse the buyer for the cost of repairs. I'm talking a few hundred dollars at the most, not thousands of dollars.

For major repairs, such as a new central air conditioning unit, furnace, or roof, you have a couple options that are superior to handing the buyer cash:

  • The seller can have the repairs completed prior to closing.

  • The seller can place an amount of money in escrow equivalent to 1.5 times the amount of the estimated cost of repairs and have the contractor paid out of escrow. Once the repairs are completed, the seller is paid whatever remains in the escrow account.

The reason the seller shouldn't just hand the money for the repairs over to the buyer is because then there is no guarantee that the repairs will be completed. If the repairs are not done, you end up in a situation in which the collateral that's backing up the loan is defective. If the borrower defaults on the loan, the collateral is not worth as much as the lender assumed it was worth when it approved the loan.

Question: What if the seller includes furniture or other extras?

Answer: Quite a few people seem to think it's okay for the buyer to agree to pay more for a home because the home is furnished or the seller agrees to throw in some extras, such as a car. When a buyer is borrowing money to purchase the home, however, this practice is unacceptable. I have seen cases in which the buyer has agreed to pay $30,000 more for a home because the seller agreed to leave furniture that was worth only a few thousand dollars at most. I don't know who was on the receiving end of the extra money, but something certainly smelled fishy about that deal.

Of course, I have sold many homes in which one or two pieces of furniture or a couple appliances were written into the contract. These are items that the buyer requests and the seller agrees to include in order to close the deal. This is perfectly acceptable, but for the buyer to agree to pay significantly more for the home because the seller is including a few extras crosses the line.

Why are arrangements like this wrong? A couple reasons:

  • A mortgage loan is secured by value of the home and the land it is on, not by the contents of the home or other extras that the seller throws in. If the homeowner were to default on the loan, move out, and take the furniture, the lender probably couldn't sell the home for enough money to cover the balance of the loan.

  • Paying more for a home than the true market value of the home artificially raises property values in the area. This makes housing less affordable for prospective buyers, increases property taxes, and makes for unstable housing markets.

Question: What if the home appraises for more than the seller is willing to accept for it?

Answer: I received the following question from a reader:

My wife is the buyer of a home. Seller will accept $280,000, the house appraises for $310,000. So, she offers $295,000 and the extra $15,000 is to be paid in real estate commissions to the buyer's agent (me). Of course we disclose in the REPC we are husband and wife, there is a signed commission agreement, and it is disclosed on the HUD's to the lender. There are no double contracts or HUD's. I've earned commissions in the past buying my own property, but I also know an agent that the lender wouldn't allow him to earn a commission buying his own property.

The key here is the phrase "Seller will accept $280,000." Regardless of how much the home appraises for, because the seller agrees to take $280,000 for the property, that is the property's sales price and it should be listed as such on the closing documents. If the appraiser had been notified that this was the net sale, the appraiser would have appraised the property for no more than $280,000. (Sometimes appraisers get dragged into the fraud arena because they are left in the dark.)

Question: Is cash back at closing okay if the details of the transaction are fully disclosed to the lender prior to closing?

Answer: This is a trick question. Most of the people who ask this question are actually not fully disclosing the details of the transaction to the lender. If they were, the lender would never approve the loan. What happens in many cases is that the con artists create two HUD-1 statements: one that discloses everything at closing and another, sent to the lender, that withholds important details. By including the details on one of the HUD-1 statements, the con artist convinces everyone that the details have been fully disclosed when they have not been.

In other cases, the HUD-1 may contain all of the details but someone pushes the loan through the approval process. Prior to the current mortgage meltdown, many lenders were so eager to have loans approved that they lowered their standards. Even though all the details of the transaction were disclosed at closing, the outcome was still the same: Lenders approved loans that should have been rejected outright. Some say that this is the lender's problem, but we all pay the price.

Question: What if the seller agrees to accept less for the property at the very last minute?

Answer: Buyers will often sign a purchase agreement conditional upon the home passing inspection and then negotiate for a seller credit just prior to closing. They may ask for additional repairs, claim that their finances have changed, or provide some other explanation for why they need a credit in order to close. The sellers may be so tired of the process at this point that they agree just so the deal will close.

When situations such as this arise and the buyer and seller agree on a lower sales price, then the paperwork needs to be amended, the lender needs to be informed, and the loan documents and approval must be reworked. If the concession is not disclosed to the lender, then there is an issue. Buyers and sellers can negotiate whatever they want, but everyone involved in the transaction must be informed.

An agreement on an addendum is not sufficient to complete the transaction.

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