Price Reduction or Seller Concessions
So picture the situation: You’ve found the perfect home with your realtor and now you’re ready to write an offer. Unless you or realtor suspect this home will have multiple offers, there’s a good chance you can sit down, take a little bit of time, and maybe try to negotiate with the seller. But what exactly can you negotiate in a contract? There’s a bunch of small things, sure, but the one thing that matters the most is the price. But it’s way more nuanced than that and there’s some fundamental mathematical principles at play here that can help you keep more money in your pocket. In this post we’re going to talk about a question I get asked all of the time, and I’m constantly advising my clients one way or the other. That is, in real estate negotiations as a buyer, do I want to ask for a lower purchase price, or do I want to ask for seller concessions, or some mixture of both?
Now before I give the answer, and there is a right answer by the way, let’s briefly go over what purchase price and seller concessions are.
Purchase price is just what it sounds like. This is the amount you’ll buy the home for and it can be negotiated. This means that if you negotiate a lower purchase price your total loan will be smaller, which in turn, means that your monthly payment will be fractionally lower. As a rule of thumb, every $20,000 financed on a 30-year fixed rate mortgage at a 5% interest rate results in a monthly payment that is approximately $100 higher. Remember this thumb rule for later.
Now Seller concessions on the other hand are a little more complicated. These are contributions from the seller in a real estate transaction towards buyers’ closing costs. Buying a home isn’t free – there are a ton of fees associated with the transaction outside of the down payment. These fees could include: attorney fees, title search and insurance fees, HOA transfer fees, loan origination fees, loan discount points or temporary buydowns, loan processing fees, various lender fees, deed recording fees, prorated interest and taxes, escrow padding, and your insurance premium. All of this can add up to something substantial – sometimes as much as 5% of the total purchase price, though in reality it’s usually about 3%. It just depends on the purchase price. So what a seller’s concession is is the seller coming in and saying that they’ll contribute a certain amount of money towards your closing costs so you don’t have to come out of pocket as much. Certain loan products have different allowable concessions – so be sure you talk to your lender about how much concessions you’re actually allowed to have. The reason why there are caps for seller concessions is that regulatory bodies such as HUD or Fannie Mae and Freddie Mac want to limit inflation of the housing prices. So for instance, if you’re using a VA loan you’re capped at 4% of the purchase price in concessions, whereas an FHA loan it’s 6%. A conventional loan for a primary residence depends on your down payment, while a conventional loan for an investment property is capped at 2%.
Also, a question I get sometimes is can you use Seller Concessions to cover your down payment? The answer is no, you cannot. And that’s where the story ends.
So now that we’ve gone over what Purchase Price and Seller concessions are, let’s go back to our original question. What is better? And here’s the answer to the question: seller concessions. Every. Single. Time. And I see three reasons why this is so. I’m also not going to state the obvious and say stuff like “as a buyer you get to keep more money in your pocket!” or “You have to bring less money to closing!”
So the first reason and probably the most important reason is this concept called the Present Value of Money. When I was attending business school this was harped on again and again because it’s one of the most important concepts in all of finance. It’s a little convoluted, but I’ll try to break it down to basic terms without getting math heavy. We can define the Present Value of Money as the idea that money today is worth more than that same amount in the future. Or in other words, money received in the future is not worth as much as an equal amount received today.
In the context of buying a home, seller concessions are essentially receiving money today. Cash that would have otherwise left your bank account for closing costs now remains in your bank.
So let’s take a random home for example. You can either buy it for 340 thousand dollars or 350 thousand dollars and 10 thousand dollars in concessions. Let’s assume you own it for 13 years which is the average length of home ownership in the United States. Obviously if you anticipate selling before the 13 year mark, then it makes the numbers even more skewed in favor of concessions, and here’s why.
So remember that thumb rule I mentioned earlier, that every 20 thousand dollars of loan amount will translate into roughly 100 dollars for your monthly payment? Well in this case, the difference between our example translates into roughly 50 dollars per month. Over the course of 13 years, that is 78 hundred dollars of interest saved if you didn’t choose the seller concessions. 78 hundred is less than 10000, so even if you held on to the home for 13 years, which statistically there’s only a 50% chance you will, you still wouldn’t recoup the full 10000 dollars in closing costs.
But interest saved is NOT the point of the present value of money. The point is the opportunity cost that the cash today provides compared with some indeterminate day in the future. Let’s assume that you could use that money to achieve an 8% annualized return in the stock market or literally any other investment. Over the course of 13 years, that is 27 thousand dollars. Think about it. 10 thousand dollars you would not have had otherwise will yield 27 thousand dollars 13 years later if you invested it wisely. That would far outpace any interest savings.
But wait, what about when you go to sell the home? You’re getting the 10000 dollars back then, right? Actually, yes. You do get that 10000 dollars back at closing when you sell the home in the future if you chose the purchase price reduction instead of the seller concessions 13 years earlier. But assuming an inflation rate of 3%, that future 10 thousand dollars is only worth 6800 dollars today, because inflation makes your money worth less. On top of that, the interest you saved over the 13 years isn’t actually worth the full 78 hundred dollars in today’s money – it’s actually worth much less, but the math is a lot .more complicated in that regard. So this is the crux of the present value of money. Any money you receive in the future WILL be worth less than the money today. And if you were to invest the money saved from concessions instead, then all bets are off and you’re setting future you up for success.
This example only skims over some fundamental principles of the present value of money. Many accountants and financial advisors can spend hours discussing this, complete with excel spreadsheets and math formulas. I’m not going to spend a blog about seller concessions discussing net present value or discount rates, but understand that this is a very real field of math that is very applicable in real estate negotiations.
So the second advantage of seller concessions over purchase price reduction is you’re helping your neighborhood comparables, which will anchor your home value. Without going into too much detail, residential homes in the United States are almost always appraised using the comparable sales approach. This means after you buy your home, appraisers will use your home as a baseline to compare future sales in your neighborhood. Your home being sold for more will justify other homes in the neighborhood being sold for more, which in turn will justify other homes being sold for more, which in turn elevates the value of your home. This effect can snowball and it’s really how some neighborhoods appreciate faster than others. It all starts with a few folks willing to buy a home for more.
Now with this, I have to point out one disadvantage to this strategy. You are not necessarily guaranteeing that the home will appraise for the purchase price, especially if you’re buying the most expensive home to ever be sold in the neighborhood. This risk is amplified if you have a ton of seller concessions written into your contract instead of purchase price reduction, and its even more amplified if the seller overpriced the home to begin with. There’s a chance that the home won’t appraise for the purchase price, and as a result, the seller will start by asking to remove the seller concessions so that they net a similar number. Also – another caveat is that if you buy a home for more, then there’s a 110% chance the county will tax you at a higher rate. We can’t escape the tax man, not ever, but in this case we’re talking dollars or tens of dollars of difference on a monthly basis.
Now the third advantage to seller concessions is only specific to VA loans, but many of my clients are VA buyers so I feel like it is applicable. Did you know you can use seller concessions in a VA loan to pay off debt or judgements? Like, you can pay off credit card debt or auto loans with seller concessions with a VA loan, with some caveats. Disclaimer: I am not a loan originator, so you need to run this by your loan officer for your specific situation. But this is kind of a hidden advantage of the VA loan that most realtors and many lenders don’t know about.
Also – and this is mostly a side note- but if you’re using a VA loan, make sure your lender is intimately familiar with them. The best analogy I’ve heard about this is to say you play golf once a year. Are you any good? Definitely not. Do you understand the basics? Sure, but your swing is going to be terrible and you’ll spend the majority of the time chasing down your balls in the woods. Now if you play golf several times a week, you’re going to be alot better. The same is true with lenders. Any lender can originate a VA loan, but most only do a handful a year, if that. Ensure your lender primarily does VA loans in order to make the most of your seller concessions.
Real quick we’re going to touch on when seller concessions are not useful. So if you’re buying a home with cash, then seller concessions or purchase price reduction doesn’t really matter. It’s all the same since you realize those savings immediately. Also, it’s possible to have too much in seller concessions. Sometimes your entire closing costs are paid for through seller concessions and you have excess. Now, you can use those excess concessions to pay down the interest rate, but sometimes that isn’t worth it either and it’s a conversation to have with your lender. In South Carolina, any excess concessions go back to the seller, so it’s incumbent on your realtor to go back to the seller and renegotiate the seller concessions and lower the purchase price. Or maybe your lender can pad your escrow account. It’s uncommon, but possible.
And lastly, let’s talk about why the seller might not like seller concessions. A common misconception is that seller concessions and purchase price reduction are the same for a seller, but that’s not actually true. A seller will have to pay realtor commissions based on the purchase price. If the seller is paying a 6% commission, the difference between a ten thousand dollar purchase price reduction and a ten thousand dollar seller concession is $600 that the seller will have to pay towards commissions. Also, a seller who doesn’t understand the topics we discussed in this video might see an offer that contains seller concessions and immediately think that the buyer isn’t as qualified since they need so much closing cost assistance, thereby making their offer more risky and less desirable. At that point it’s important for the buyer’s realtor to dissuade those thoughts.
So those are my thoughts on why seller concessions win every time over purchase price reduction.
