Some real estate markets are very competitive. If you're looking to buy a new home and need the proceeds from the sale of your existing property to make a down payment, you may be frustrated with the choices you're faced with.
Sellers in hot markets benefit from multiple offers and low, quick-moving inventory. These hurdles are problematic for buyers, but especially those on a tight timetable before their current home is scheduled to close. If you're confident your home will sell very quickly, you may prefer to buy your new home before selling the old one. But how will you raise enough cash for the down payment? Although challenging, you do have some options.
Selling then buying can get expensive
Selling before buying is the way most people buy a home as the proceeds from the sale of a current home is usually required to buy a new one. Even with the the cash on hand for the down payment, it is much harder to qualify for a new mortgage while carrying debt on the existing home. For lenders, your intention to sell doesn't change the current facts.
The problem with selling then buying a home is the cost and logistical issues of the "limbo" time in between and the risk of not being able to secure your next home in a competitive marketplace. Be sure to plan for the following considerations:
- Where will you live after selling your home? Can you live with family or friends? What are your short-term rental options?
- Can you use a contingency as either a buyer or seller to help bridge the time gap?
- What is your budget for the transition? Consider short-term housing, moving expenses, storage, realtor fees, and so on. Will these costs require you to dip into your down payment?
Coming up with a down payment when buying a new home before selling the old one
Buying a home before selling your old one is undoubtedly a risky endeavor. What if your current home doesn't sell as quickly - or for as much - as you planned? Although there's an inherent risk involved with this method, in a seller's market, there's less risk involved in most cases.
There are two big roadblocks individuals in this situation often face:
- Coming up with a down payment
- Staying within an acceptable debt to income ratio while carrying both properties
Keep in mind that many of the options to help solve problem #1 will hurt your efforts in solving problem #2. Work with your financial advisor to review your options and discuss how a particular strategy may impact your overall situation before taking action.
Taking a loan from your 401(k)
Ask your plan administrator or HR department whether 401(k) loans are permitted under the plan. If so, find out the repayment period, interest rate, and terms associated with personal residence loans. The amount you can borrow will also depend on the plan, but cannot exceed IRS guidelines which stipulate that "the maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less."
401(k) loan benefits and considerations:
- If you plan on using proceeds from the sale of your existing home to repay yourself, a loan from your 401(k) to purchase a primary residence may be a good option. Plans can often disburse loans fairly quickly, so ideally you won't even need to take a loan until your offer has been accepted.
- Many lenders see 401(k) loans as borrowing from yourself, so your debt ratio usually isn't affected.
- Be sure to understand the terms of the loan and what the estimated monthly payment will be. Pre-tax 401(k) contributions will result in a pre-tax loan. Therefore monthly repayments (usually made by payroll deductions) will be after-tax. If you plan to repay yourself with a lump sum after closing, confirm whether that's possible.
- If you plan on taking a substantial loan and can't afford to repay yourself quickly thereafter, this strategy may do more harm than good. Studies have shown many individuals who take a 401(k) loan end up worse off in the long run.
Using home equity
A home equity line of credit (HELOC) or a home equity loan are ways for buyers to tap their existing home's equity before selling the property. A home equity loan is essentially a second mortgage to provide cash that can be used for any purpose. Like a mortgage, a home equity loan will have a one-time equity draw, typically a fixed interest rate, and monthly repayments. In a home equity line of credit, you may access all or portions of your equity line during the draw period, but aren’t required to take out the entire amount. Interest rates and terms will vary.
How much can you borrow? Most institutions will only lend up to 80 percent of a property’s combined loan-to-value ratio (CLTV). Here’s an example:
Benefits and considerations for using home equity:
- The biggest risk in using home equity is that you're further leveraging your property and take on the added risk of being under water or losing the property if you cannot keep up with the payments.
- Low interest rates make using home equity an attractive option. A portion of the interest paid may even be tax-deductible, subject to limitations.
- This method is unique in that it allows you to use your home's equity before you sell, rather than to repay yourself (or another third party) afterwards.
- Banks do not often allow either method of the home is already on the market. Secure your home equity loan or HELOC first. At the closing of your old home, the equity you withdrew will become due in full. Make sure your projected sale price is conservative enough to cover your debts and selling expenses.
- Make sure you understand the impact on your ability to buy. Your lender on the new property will include your monthly payment (or estimated payment) in your debt ratio. Also, your credit score may suffer as a result of the additional leverage.
- Review the terms and fees. There is often a minimum draw requirement and an early termination fee.
Doing a cash-out refinance
A cash-out refinance is very similar to a home equity loan or HELOC in that you are using the equity in your existing home and turning it into cash. Unlike the options previously discussed that represent a secondary lien on your home, refinancing pays off your existing first mortgage and you begin a new one. With a cash-out refinance, you take a portion of your equity (around 80%) and the bank pays you the amount in cash and then adds the payout to your new, larger, refinanced mortgage.
Benefits and considerations of a cash-out refinance:
- Refinancing may provide a better interest rate than the other ways you can use your home's equity.
- If the interest rate on your existing mortgage is high, you may be able to refinance without much change in your monthly payments.
- The same considerations that apply to the preceding options apply to a cash-out refinance: foreclose risk, debt ratio and credit score implications, and the ability to repay the note at closing.
- A cash-out refinance may be quite costly so make sure you understand the terms. Closing costs can be 5% or more of the loan amount, which can significantly offset the benefits of using this method to raise cash for a down payment.
Many lenders will accept a gift from a family member as a portion of the down payment. For jumbo or non-conforming loans, a gift cannot be the full down payment, but some lenders will only require the buyer to put up 5% of their own funds. To obtain a gift to help with the down payment, the donor will need to complete a gift letter and provide some other financial information such as copies of bank statements. A stipulation of the gift is that it is not a loan and won't be repaid.
Benefits and considerations of getting a gift:
- Free money! Obviously this is the biggest benefit of getting a gift. It has no impact on your debts as the donor will have to sign an agreement stating that the gift won't be repaid.
- Gift tax considerations. Depending on the gift amount and the tax situation of the donor, the IRS may consider it a taxable gift. Ensure the donor consults a tax professional prior to signing any paperwork.
- Some lenders may require that a gift is "seasoned." If there is a seasoning requirement, the gifted funds need to be in your bank account and reflected on your bank statements for a stipulated period of time before qualifying.
Putting down less than 20%
For buyers looking to purchase a home under the conforming loan limits, a 20% down payment is not required and many institutions will underwrite the loan. The difficulty is when non-conforming or jumbo loan buyers don't have the cash in hand for a 20% down payment. Recently, more options have become available again for these buyers. Your options will depend on where you're looking to purchase. Different states and counties have varying loan maximums that determine what's conforming and what isn't. Further, some lenders are only licensed in certain states. For example, SoFi recently announced a mortgage program where qualified buyers can put 10% down on homes up to $3M without private mortgage insurance (PMI).
More common offerings for big-budget borrowers with at least 10% down are 80/10/10 loans where 80% of the loan is financed in a traditional, often 30-year fixed mortgage, while 10% is a home equity line of credit on the new property and the remaining 10% is the down payment. The same considerations about HELOCs previously discussed apply. Other lenders may offer a similar arrangement but require at least 15% down, so the loan would be 75/15/10. Buyers with down payments of 15% sometimes qualify for a mortgage without a home equity line of credit, although it may be less than 30 years and include private mortgage insurance.
Benefits and considerations for buyers in higher price ranges and a smaller down payment:
- Always make sure the purchase price and monthly payments are within your comfort level. Just because someone is willing to lend you a certain amount does not mean you can afford it. You know your expenses and cash flows better than anyone.
- Buyers without 20% will pay a higher interest rate as their loans carry a higher risk. They will also have fewer choices when selecting a lender.
- Putting less down means having a higher monthly payment. Since you're already carrying your old home, this may put you over the top of allowable debt to income ratios.
- A possible benefit to this approach (assuming it coincides with your financials) is that it may enable you to purchase the home without engaging in some of the riskier strategies involving your current home's equity. When you do subsequently sell the existing home you can take a portion of your actual proceeds to prepay your HELOC, make equity-building improvements, or diversify by investing cash in the market. With this approach, you avoid having to spend down your old home's equity based on projections.
- In a competitive market, it can be especially difficult for buyers with lower down payment to stand out among stronger offers. Discuss how this may impact your ability to compete with your real estate agent.
Using a sale-leaseback contingency
Contingencies are a common way buyers and sellers protect their interests when buying property or negotiating a deal. A seller may request a sale-leaseback to (literally) buy them some more time to purchase a new home after selling theirs. As part of the negotiations, the buyer and seller of the home will agree on how long the leaseback will be and the monthly rent.
In a seller's market, buyers may be more willing to accept this type of contingency than they would have otherwise. Also, depending on the buyer's current situation, it may be beneficial to both parties. As a seller, the benefit of a sale-leaseback is that you can finalize the sale and raise the needed cash to buy a new property without having to move.
Benefits and considerations of using a sale-leaseback:
- You are still on a timetable. As a buyer in a popular neighborhood, it may take some time to find and secure your next home. Even if the buyer agrees, you still may need to move before your closing date or could end up carrying both rent and a mortgage.
- If you already have an offer accepted on a new property, you know your closing date. Assuming your buyers are fine with your proposed time line, a sale-leaseback can work very well.
- Keep in mind the monthly rent charged by the buyers will likely be much higher than your mortgage. It will be at a current market rate. You will save yourself the hassle of moving and living out of boxes while you find a place, but your short-term expenses are still likely to go up.