A down payment is the monetary difference between the loan amount and the agreed transaction price between buyer and seller.
Some circles describe down payment as the difference in loan amount and value of property.
But as transaction prices are often above or below value, the closing price is a better measure of down payment for borrowers.
Yet as lenders use valuation to work out loan to value, lenders use valuation as the base for calculating down payment as a percentage of loan amount.
This can have big implications.
For example, if a house is valued at $250,000 and transacted at $280,000, with a borrower needing 90% financing to close the deal, he might not be able to obtain the total funds from one lender.
This is because even though he views 90% financing as amounting to $252,000, a lender would view 90% as $225,000. Leaving the borrower short by $27,000.
Going deeper into this example, should the borrower be able to find that extra $27,000 from other sources, maybe from family members, he would be making a 20% down payment in total from his perspective.
But from the lender’s perspective, the down payment remains at 10% as they only took into account the valuation of the property.
This makes private mortgage insurance a requirement in order to underwrite the mortgage.
In order to avoid PMI, the borrower needs to source for more cash upfront.
Mortgage insurance and LTV
The relationship between down payment and PMI is very close when borrowers are targeting that 80% magic LTV number to avoid PMI.
If we go back to the previous example of a $250,000 house. This time it is transacted at market value.
Suppose the buyer intends to sign up for a 80% loan to stay an inch away from requiring PMI. The loan would now be $200,000 with a $50,000 down payment helping the borrower deftly sidestep PMI.
But should the lender be financing points or settlement costs of say $3,000, the total loan will now become $203,000, pushing the loan quantum beyond the 80% LTV mark. Making private mortgage insurance an obligation.
In reality, or at least in the eyes of the lender which is what matters in this instance, the down payment is technically just 19%.
But if the tables are flipped and the house is now purchased below value at a price of $225,000, a lender will take $225,000 as the value of property as they use the price or value whichever is lower in determining LTV and down payment.
In this case, the borrower will still have to fork out 20% of $225,000 to avoid PMI even though the property is valued at $250,000. And a little more if financing point and settlement costs are packaged into the deal.
However, in certain circumstances, the value of the property can be used to determine LTV even though the sale price is much lower than value.
Gift of equity and cash gift
A gift of equity is basically a transaction whereby a property is sold for much less than what it’s worth on the open market.
These types of events usually only occur between family members.
If two unrelated parties proceed with such a transaction, a lender would more likely view it as a weak attempt at mortgage fraud rather than a gift of equity.
In these situations, the lender might demand more documentation to prove that it is a legitimate gift of equity. And not just some punks trying to game the system.
When dealing with gifts of equity, take note of how they might potentially be liable for gift taxes.
This is different from a cash gift where down payment is contributed by people as gifts.
Cash gifts are permitted by lenders but they usually require that the borrower contribute a certain amount towards the down payment.
Sometimes a gift letter is required to prove that funds originate from a gift instead of a loan from a donor.
But the truth is that when you have the cash to make the down payment, the lender probably wouldn’t ask about the source of funds unless in unique circumstances.
Even so, they would realize that they are just wasting their time when the funds are gifts. It makes no significant difference to the deal…
… except when the buyer needs that little extra push in valuation to obtain a bigger loan.
For example, when there are home seller contributions involved in a deal, it means that the seller is giving a gift to the buyer so that he can afford the house.
This act can effectively raise the loan amount by increasing value which the appraiser signs off on. And it can be legitimately done as long as it conforms to standards set by lenders and insurers.
Land value is treated differently in many circumstances in the real estate industry.
But for the most part, it is calculated by taking the appraised value of the property minus the costs of building the house (improvements). The result is the land value.
For example, if a property is appraised and purchased at $300,000 and the cost of building the house is $240,000, the land value would be $60,000.
In this case, a loan for $240,000 would be 80% LTV with the land value of $60,000 serving as down payment.
However, do note that purchase price is not equal to appraised value.
There’s every likelihood that an appraiser appointed by a lender can value the property higher or lower than the purchase price.
This would affect loan amount and loan to value accordingly.
This is right up the alley of investment banks.
They play by a different set of rules to serve affluent clientele with high net worth.
However what defines high net worth is up to interpretation.
What happens is that they would demand assets to be deposited with them, and in return would finance up to 100% of the home purchase.
The most common assets are securities and cash.
This method of lending has been so successful that many consumers banks have followed in the footsteps with what is termed asset based lending (ABL).
As long as a borrower has satisfactory credit, a lender could approve a mortgage instantaneously if he can show documented proof to verify the ownership of personal assets worth a certain value.
However, the amount borrower will still be limited by LTV restrictions and guidelines. And also minimum down payment requirements.
This method of borrowing is commonly used by wealthy individuals with too little or too complex income, and just prefer to go this route with an application process that is so much easier.