How can a “carpeting allowance” be a bad thing?

On many real estate sales contracts we see credits from the seller to the buyer in the form of “carpeting allowances” or “repair credit.” Basically, a buyer wants to purchase a home but wants the seller to replace the carpet or make some other repairs to the property. The sellers are unwilling to make the repairs before the close of the property, either because they don’t want to pay for the repairs out of their own pockets or they don’t want to wait to close on the property. So the sellers agree to give the buyers a credit at closing out of the proceeds from the sale.

So, what’s the problem? Sounds like everyone is getting what they want.

The problem with this is that the lender will not usually allow a credit directly from the seller to the buyer at closing. They will allow the seller to pay for closing costs, and other prepaid items for the buyer, but the money does not go directly TO the buyer. One of the reasons for this is that sellers are not allowed to provide the down payment for a home purchase to the buyers. So lenders do not allow these types of 'repair credits' because it would be an easy way for sellers to get around the no-down-payment rule.

When there is a repair credit on the contract, the lender will reduce the sales price by the amount of the repair credit and calculate the loan to value (LTV) off of that reduced sales price. For many transactions this will not have much of an affect. If the buyer has a large down payment, and if the repair credit is relatively small, the buyer will not really notice any difference.

The problems arise when the buyer has a smaller down payment, and/or the repair credit is large relative to the sales price of the property. Let’s look at the following transaction:

Sales Price: $150,000
Down payment (5%): $7,500
Mortgage $142,500

Let’s now assume that the seller is giving the buyer a $3,500 carpeting allowance at closing. The lender will reduce the sales price by the allowance and calculate the LTV off of that sales price.

Sales Price: $150,000
Allowance: $3,500
Effective Sales Price: $146,500
Mortgage $142,500
LTV: 97.2%

Now, the buyer thought they were going to be able to do a 95% LTV Conforming Fixed Rate loan. Because of the credit at closing, they either have to increase their down payment to $10,825 which would give them a loan amount of $139,175 and an LTV of 95% or, they would have to get a different mortgage program that allowed for a higher LTV. Most likely, since the buyer was only putting 5% down on the property in the first place, the second option is the most likely one. And, the mortgage programs available to the buyer now, would usually result in a higher interest rate and/or higher mortgage insurance payments on the program.


So, what can we do so everyone comes out a winner?

There are a few ways to deal with repair credits that will accomplish the goals of the credits without breaking the rules or harming the buyer. Here are three:

1) The seller agrees to lower the sales price by the amount of the credit. The sellers will still walk away with the same amount of proceeds from the sale of the home and the buyer will still be able to make a smaller down payment and get the mortgage they initially wanted. The buyers are also getting a better sales price. Unfortunately, the repairs have still not been completed and the buyers will now have to make these repairs with their own money. Chances are, they do not have the money to make the repairs or they would not have asked for the credit in the first place.

2) You can write in the contract that the seller agrees to pay a certain amount of money to a contractor of the buyer’s choice from the seller’s proceeds at closing instead of making the repairs. The money is not going directly from the seller to the buyer – it is going to the contractor for repairs agreed upon in the contract. This would have to be approved by the lender.

3) The seller can get bids for the work that needs to be completed and agree to set up an escrow account for the work to be performed after closing. The work will have to be completed, and an inspection will need to be performed, before the money will be released from the escrow account. Any money left in the escrow account after the repairs have been made will go back to the seller unless other arrangements were made. This is generally more acceptable to the lender since the money is held in escrow until the work in performed and the lender will verify that the work has been completed.

Although seller credits have not been allowed by mortgage lenders for quite awhile, I do still see them written into contracts. Many Realtors and attorneys are not aware of this, so if they are written into your contract, make sure it's done properly.

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