July 10, 2000, Revised November 16, 2006, February 23, 2007

Seller contributions to a buyer's settlement costs, accompanied by a higher sale price ratified by an appraiser, are a scam if the lender doesn't know about it. It can be legitimate if the lender does know about it and the contribution falls within the limits set by the lender.

When a Seller Contribution is a Scam

“I offered $289K for a house but was not able to make a down payment. The seller’s realtor told me that so long as I could pay all the closing costs, they would find a way to contribute 5% toward a down payment. When we sat down to sign the contract, the realtor had increased the price of the house to $304K, and had a second mortgage contract from the seller for $15K. I was told that the seller was lending me the $15K for the down payment, and would "forgive" the loan after the closing. So I end up with a house worth $289K and one mortgage for $289K, and all I bring to the table is the closing costs. Is this kosher?"

No. The lender is being scammed, and if you go along with it you will be a participant in the scam.

The lender is being led to believe that he is getting a loan with a 5% down payment. The paperwork shows a price of $304K for the house, and a first mortgage loan of $289K, with $15K of equity provided by the buyer. But in truth there is no equity because the house is only worth $289K.

For this scam to work, the appraisal of the property must come in at $304K. This means that the appraiser is either hoodwinked by the fictitious sale price, or is a party to the scam.

And you will be a party to it as well. For the loan to close, you will be obliged to lie about the source of the funds used for the down payment.

Assuming the deception is not caught and the loan goes through, it might be caught in a post-closing audit, in which event the lender could elect to call the loan. All mortgage loans contain an “acceleration clause” which allows the lender to demand immediate repayment if any information provided by the borrower turns out to be false.

If your deception is not caught in a post-closing audit but sometime down the road you have difficulty making your mortgage payments, the same thing could happen. If they find you lied, you will get summary justice.

If your credit is good, you don’t need to cheat to get 100% financing. It is available in the form of combination loans – 80% first mortgage and 20% second mortgage. It is also available as 100% first mortgage. You need a mortgage broker who is familiar with these options.

When a Seller Contribution is Legitimate

"At another mortgage information website, I was reading about ways to purchase a house when you have very little cash. One way was to ask the seller to increase the sale price and contribute the increase to the buyer’s cash requirement. Is this legitimate?"

It is legitimate, provided you do not conceal it from the lender, and the contribution pays settlement costs rather than the buyer’s down payment.

Home sellers often gift buyers. The purpose is to improve the buyer’s ability to purchase the house by reducing the required cash. For it to work, the appraiser must report that the house is worth the higher price.

For example, Jones offers his house to Smith for $200,000, which Smith is willing to pay. But under the best financing terms available to Smith, he needs $12,000, which he doesn’t have. This is shown in the "Before" column of the table.

	Before	After
Sale Price	$200,000	$206,000
Appraised Value		$206,000
Loan Amount	$194,000	$199,820
Down Payment (3%)	$6,000	$6,180
Total Cash Required	$12,000	$6,360
Down Payment (3%)	$6,000	$6,180
Settlement Costs (3%)	$6,000	$6,180
Gift From Seller	0	$6,000
Buyer’s Stated Equity	$6,000	$6,180
Buyer’s Real Equity	$6,000-$12,000	$180-$6,180

So Jones and Smith agree that Jones will raise the price of the house to $206,000 and Jones will gift Smith $6,000. Assuming the appraiser goes along, the amount of cash required of Smith drops from $12,000 to $6,360, making the purchase affordable. Jones gets his price and Smith gets his house, so everyone is happy -- except, perhaps, the lender.

Appraisals often ratify sale prices, whether justified or not. If the house is actually only worth the original offer price of $200,000, the buyer has only $180 of real equity -- the difference between the original property value and the higher loan amount -- rather than $6,180. Less equity means greater loss for the lender if the loan goes into default.

For this reason, lenders and mortgage insurers limit seller contributions to buyers. The smaller the down payment requirement, the more critical the issue becomes. On conventional loans (loans not insured by the Federal Government), it is common to restrict seller contributions to 3% of sale price with 5% down, and to 6% with 10% down.

FHA Rules on Seller Contributions

On FHA loans, sellers can contribute up to 6% of price to the buyer’s settlement costs, but nothing to the down payment. FHA seems to believe that by limiting seller contributions to the buyer’s settlement costs, the equity is protected. But this is true only if the house is actually worth the sale price inflated by the buyer’s contribution.

For example, assume the seller marks up the house price from $100,000 to $106,000 based on a $6,000 contribution but the house is worth only $100,000. Then with a loan of $102,820 and a down payment of $3180 (3%), the borrower’s equity is minus $2,820.

Whether the $6,000 is used to pay settlement costs or down payment, furthermore, doesn’t matter. The impact of seller contributions on price depends on the size of the total contribution.

FHA allows a contribution to the down payment, but it must be an outright gift from a family member or friend, the borrower’s employer or union, a charity, a government agency, or a nonprofit corporation or charity. Such gifts don’t cause price inflation, so the borrower’s equity is protected.

But FHA allows approved entities to affiliate with sellers. Several nonprofit corporations have developed programs offering down payment assistance using funds provided by sellers. These include www.nehemiah.org, www.partnersincharity.org and www.ameridream.org.

These programs have opened homeownership opportunities for a segment of the population that would otherwise be shut out of the market. On the other hand, since the funds for down payment assistance come from sellers, they cause price inflation. The combination of direct seller contributions to settlement costs on an FHA loan and indirect contributions through down payment assistance programs can add up to 9-10% of sale price.

The only rationale for allowing seller-provided assistance through intermediaries that is prohibited when made directly is that the intermediaries add value. For example, the course in home ownership that Nehemiah requires borrowers to take might reduce risk to FHA. FHA ought to establish what the benefits are or could be, and set standards for the entities.

Alternatively, FHA should scrap the distinction between contributions to settlement costs and to the down payment, and adopt the practice of the conventional market of limiting the total contribution of sellers. In line with FHA’s social agenda, maximums tied to the buyer’s cash investment could be more liberal than in the conventional market.