Why You Can’t Use Cash to Make a Down Payment

November 14, 2016

You generally cannot use cash – as in physical cash – to make a down payment on a home. While that might seem unfair, mortgage lenders have to operate by certain procedures that are designed to protect the integrity of the mortgage loans that they make.

The problem with cash is that there is no solid way to track where it comes from. And because of certain requirements within the mortgage industry, cash doesn’t fit neatly within the guidelines. For that reason, you generally cannot use cash to make a down payment on a home.

The “Own Funds” Requirement

One of the complications with conventional mortgages is that they usually require that you have a certain minimum amount put toward the purchase of a home. This is particularly true any time that the total down payment on the new home is less than 20%.

That minimum requirement is usually somewhere between 3% and 5% of the purchase price. Conventional mortgage rules hold that at least that amount of the down payment must come from your own funds. That contribution for the down represents your actual equity in the home, apart from any gifts or secondary financing that you might obtain to cover the rest of the down payment.

Conventional mortgages have this own funds requirement because lending experience has shown that a homeowner is much less likely to default on a mortgage if they have an actual equity stake in the property. As such, the own funds requirement is typically not negotiable.

For this reason, lenders will look for a paper trail documenting both the existence and the source of your down payment funds. Since this is easier to do when money is sitting in a bank account or investment account, rather than in cash-on-hand, lenders will generally not accept actual cash as part of the down payment.

The Money Could be Borrowed

One of the problems with physical cash is that it can’t be traced. That holds open the possibility that the money could be borrowed. For example, you can get a cash loan from a friend, and tell the lender that it’s your money.

Should the lender accept physical cash as part of your down payment, they will have no way to verify whether or not the money was borrowed.

One of the situations lenders are always on the lookout for is what are known as sleeping seconds. This is when borrowed money is presented as the buyer’s funds at the time of loan application. But after the closing, a new lien is recorded on the property in the form of a second mortgage.

When that happens, the lender is suddenly faced with the prospect of having made a higher risk loan than originally anticipated. For example, if the lender provides you with 90% of the purchase price as a new first mortgage, but the second mortgage for 10% of the purchase price is recorded shortly after closing, you’ve completed a 0% down payment purchase. That’s a much riskier loan than one in which the borrower had 10% down.

And once again, the borrower will not meet the own funds requirement if the cash down payment was a loan.

The Money Could be a Gift

The same situation can occur with a gift. Let’s consider a homebuyer who does a 95% first mortgage, and puts 5% down as cash-on-hand. If the cash-on-hand is the result of a gift from a friend or family member, the homebuyer has no equity stake in the property.

Once again, the difference between a homebuyer that makes a 5% down payment out of their funds, and having no equity in the purchase, has a significant negative impact on loan performance. And this is in addition to the fact that they may not meet the own funds requirement.

The Money Could be from Illegal Sources

Technically speaking mortgage lenders are not in the business of investigating illegal sources of cash. However, they are the lookout to not accept money from such sources. And unfortunately, physical cash does have the potential to be the result of illegal activity.

The USA Patriot Act

The USA Patriot Act was passed after the 9/11 attacks, and all financial institutions are required to observe it. The law specifically requires all appropriate elements of the financial services industry to report potential money laundering. That includes the use of physical cash in the purchase of major assets, such as real estate.

The law effectively prohibits lenders from accepting physical cash as a source of funds for down payments beyond a very minimal level.

Cash “Seasoning” Requirements for Mortgage Down Payments

Earlier I mentioned that mortgage lenders are required to show a paper trail when it comes to documenting funds used to close on a new home. This requires that down payment and closing costs funds are verified as being sourced from a financial institution. This can be done either with recent copies of bank statements, or through a form known in the industry as a verification of deposit, or VOD, which is sent directly to a financial institution to verify funds.

One of the questions that the VOD form asks of financial institutions is that they provide an average balance on the account for the past two months. If bank statements are used to verify funds, lenders will require statements covering the most recent two-month period.

The purpose of this two-month look-back is to determine if there has been any significant increase in your bank balances over the past 60 days. This is a standard procedure mortgage lenders use to determine if loans or gifts may be the cause behind the sudden increase in your balance. The 60 day look back period is often referred to as seasoning of funds, which is the process by which a lender determines if a down payment source is acceptable.

If they identify a significant increase in your account balance, the lender will then require that you provide documentation as to the source of funds. You will then have to prove that the source of the increase in your account balance was not either a loan or gift.

Lenders can be pretty stubborn about this requirement. For that reason, you should make sure you have your down payment money sitting quietly in a bank account for at least 60 days before applying for a mortgage.

It’s a pretty complicated process, and it can even seem intrusive. But it’s one of the ways that lenders make sure that down payment money from a homebuyer is exactly what it is claimed to be. But if physical cash is used as a part of the down payment, the lender will have no ability to make that determination.

So if you have a bunch of cash sitting around the house, and you’d like to use it as a down payment on your next house, you now understand why a mortgage lender won’t accept it.

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