Understanding Closing Cost Credits

Some transactions are so simple.  If your neighbor agrees to sell you his bicycle for $100, you can walk right over there, hand him a $100 bill and ride the bike home!  Unfortunately, purchasing real estate isn’t quite that easy.  Large amounts of money being transferred between individuals can introduce complications, even if the transaction itself it a simple one.  Today we are going to talk about one of these complications called closing cost credits.

When a real estate transaction closes, there is a variety of costs and credits associated with the purchase.  Each cost or credit is assigned to either the Seller or the Buyer.  These costs and credits are balanced out to determine a final amount of money the Buyer must provide to purchase the home.  Here is a simplified example of this list of costs and credits:

This is a partial list of costs, and doesn’t include some large and important items, but it serves the purpose of our explanation.  From the chart above, we can see what is a cost to one party may be a credit to the other party, but this isn’t always the case.  For example, the Seller is responsible for paying their listing broker, and those funds are not credited to the Buyer.  Likewise, there are many costs, some small and some large, to the Buyer, for which the Seller does not receive any credit.

Here is where we get to closing cost credits.  There are times when a Buyer wishes to request monetary consideration from the Seller.  A closing cost credit is often a great way to handle this request.  Here are two examples to illustrate how a closing cost credit works, along with an explanation of the pros and cons.

Example one:  The Buyer’s inspection report discloses a defect to which the Buyer objects.

The Buyer wishes to ask the Seller for compensation for the expense of fixing that defect.  The Buyer could request that the Seller lower the price OR they can request a closing cost credit.  If the Buyer is financing the purchase, lowering the price by a few thousand dollars will have the effect of lowering their monthly payments very slightly over the life of their loan, which hardly puts money in their pocket today to pay for the repairs needed.  With a closing cost credit, on the other hand, the Seller would agree to pay for a certain amount of the Buyer’s costs, effectively moving those items to their side of the chart.  Since the Buyer no longer has to pay for these items at closing, they will have more money in their pocket immediately to cover the anticipated expenses.

Example two: The Buyer does not have enough cash on hand to pay for all the closing costs plus their down payment.

The Buyer toured the property, loves it and would like to make an offer.  They feel the asking price is fair and decide to offer the Seller what they are asking for.  Their lender estimates that if they make a $30,000 down payment, their closing costs will be approximately $5,000.  The Buyer doesn’t have $35,000 in cash, so needs a solution to make their offer possible.

In this case, it is not unusual for a Buyer to increase the purchase price on their offer by $5,000, and then ask for that $5,000 back in the form of a closing cost credit.  This effectively allows the Buyer to finance their closing costs, since their starting loan balance will be increased to reflect the higher purchase price.

You may be asking yourself why monetary consideration between the Buyer and Seller must be in the form of a closing cost credit.  Why can’t the Seller simply write a check to the Buyer and be done with it? This is no longer allowed, since around 2009 all mortgage companies and regulators put a stop to this practice.  Permitting Sellers to pay unregulated funds to Buyers at or after closing created too much opportunity for fraud in the lending market, which was one of the main causes of the 2008 financial crisis.  Limiting the financial consideration to closing costs prevents Buyers from offering unjustifiable prices for real estate, borrowing many thousands more than the home is worth, all with a promise from the Seller to kick back some of those funds to the Buyer at closing.

Here are some common FAQ regarding closing cost credits:

Q: How much money can a Buyer request for a closing cost credit?

A: The lender involved will have to assess the transaction to determine the total closing costs to the Buyer.  This amount will the be the maximum that the Seller can credit to the Buyer.

Q: How is a closing cost requested?

A: In our Example 1 above (request made after inspection), the closing cost credit would be requested with a proposed amendment to the offer. In Example 2 (request made as part of the original offer process), the closing cost credit would be requested on LINE 10 of the Addendum A to Offer to Purchase.

Q: What happens if the actual costs are less than the promised credit?

A: Any funds remaining after the Buyer’s closing costs have been covered are credited back to the Seller.

Q: What are pre-payables, and do they qualify for a closing-cost credit as well?

A: Pre-payables may include things like pre-payment of property taxes (for a limited period into the future), pre-payment of home-owner’s insurance, and mortgage interest.  These items may be included as part of the Buyer’s closing costs, thereby increasing the allowable size for a credit.

Q: Is there a downside of closing costs credits? 

A: For Buyers, the closing cost credit itself presents no downside, but if the offer price has been increased to compensate for the credit (Example 2), the Buyer’s monthly payments will be slightly higher resulting from the higher initial loan balance. 

For Sellers, a price reduction may present slight advantages over a closing cost credit for the following reasons:

• Lowering the purchase price will lower the brokerage fees owed by the Seller because brokerage fees are generally calculated as a percentage of the sale price.
• Raising the purchase price to compensate for a closing cost credit request increases the risk of appraisal problems. (for more on this, read our post on Appraisals)
• A lower purchase price may decrease the Seller’s tax liability (of course consult with your attorney or tax consultant to get clarity on your own situation)

Sellers should consider these three issues before agreeing to any closing cost credit, but even more so as the credit size increases, amplifying the above issues.

Some Sellers may interpret a Buyer’s request for a closing cost credit as a signal that the Buyer is not financially strong enough to complete the purchase, and could decide to accept an offer from a Buyer perceived to be more financially stable.

In conclusion, a closing cost credit may be an excellent and convenient way to address various financial challenges within a real estate transaction, but the pros and cons listed above should be considered carefully before making any final decision by both Buyers and Sellers.

We hope you found today’s post informative and interesting.  If you have any questions or comments, we’d love to hear from you!  Click “Request a Realtor” at the top of this page and we’ll be in touch!