Cash to Close
Many people frequently ask how much is the down payment. This is important, but the most important question is how much cash do they need to close. Cash to close is an important underwriting point of consideration. Cash to close is also an important consideration for the real estate buyer. When considering purchasing real estate as an investment please consider these factors when you calculate cash to close. Consider Down Payment, closing costs, and reserves.
This is the most straight forward and simplest calculation. Depending on the program ascertain what percentage of the purchase price will the lender require as a down payment. This is usually the largest cost of purchasing an investment property and is therefore the most concern. It is not the only costs. New investors often do not realize other costs involved in every real estate investment purchase. We will explore the other options here.
There are different categories of closing costs. To calculate some without counting others will leave a borrower short of funds to close. Closing costs are broken down into these categories. They are lender origination fee and points, lender costs, third party expenses, title / escrow charges and reserves.
- Origination Fee and Points: This is the charge lender and or mortgage broker charge to do the loan for you. For residential and commercial investment real estate this fee is always present. It represents the only guarantee of income to the lenders because the lenders rarely actually make money off of the interest. The interest goes tho the lenders investors who use their institutional of personal moneys to invest in real estate loans. The origination fee or points are a percentage of the loan amount. One percent equals One point. The origination fee will vary greatly depending on the type of loan, the loan size, and the borrowers qualifications. The origination fee and points on a conventional owner occupied residential mortgage represent something else and these loans are often done with no points. That is never the case with investment real estate.
- Third Party Fees: This includes appraisal and any property inspections. These are upfront costs paid for by the borrower. The lender assumes no risk for investing in the property if the property condition does not support the loan. There is almost always an appraisal or inspection to determine value of the property. For rehab loans the lender may require in inspection prior to closing to determine the extent of the rehab and the use that same inspector or inspection company to inspect the work completed for each draw. For many types of commercial properties and even residential properties in certain locations an environmental inspection is required. These upfront third party fees are either advanced to the lender (sometimes as an expense escrow which is common in commercial transactions) or they are paid directly to the third party as the work is started. This is at the sole discretion of the lender. Additionally, the borrower does not choose who will do the third party inspections. The inspections are for the purpose of protecting the lender, not getting the outcome the borrower wants. Third party fees are not nearly as significant an amount of money as down payment, but it is always a concern to the borrower as these fees are at risk because they are paid prior to the lender agreeing to fund the loan.
- Title / Escrow Charges: These are third party fees that are not paid until closing. These fees include title policies, escrow closing services, governmental fees and attorney fees. Mandatory for all loans but more palatable to investors because they are paid at closing and do not represent a risk of funds. What many new investors neglect is adding (subtracting really) the costs of these fees (including tax and insurance escrows) to their bottom line.
- Reserves: There are three types of reserves a lender may be concerned about. First, most rehab loans require the funds they lend to be place in a rehab escrow and are disbursed as the work is completed. This means the borrower needs to complete work before a draw is given them. In essence they need to have a percentage of the rehab funds available to start the work. A second type of reserve is for cost overruns. A smart investor would include a 5% to 10% cushion of the renovation budget to cost overruns. The lenders are also concerned that a borrower has cash leftover after closing to deal with any cost overrun challenges. Finally, borrowers are required to have payment reserves. These are not funds needed to spend, but lenders want to ensure the borrower may have enough liquid funds to make payments for 3, 6 or even 12 months depending on the program.
Though these cash to close requirements are underwriting requirements they are good for the borrower in the business of real estate investing to know and understand. Cash reserves are really key for investors because many investors fail because of lack of adequate cash reserves. To be adequately prepared an investor needs to fully understand that the cash to close is a much different number than down payment. With reserve requirements cash to close is often more than twice the down payment.