The Cash-Back Was Never Intended as a Down Payment
With the prohibition of 100% mortgage financing, lenders offered the 5% cash-back to help pay for legal fees, land transfer tax and other closing costs; never was it intended to be used for a down payment. Curiously, though, the cash-back has often managed to sneak its way into use as a buyer’s down payment. Banks have stopped the cash-back practice for some time now and, of late, only credit unions offered it.
Abuse has Eliminated it. Under the National Housing Act, mortgages on purchases with less than 20% down must be insured. To qualify for an insured mortgage, the buyer must put down a minimum of 5% of the purchase price from his own resources. But as of June 30, 2015, mortgage insurers will no longer insure mortgages in which a buyer received 5% cash-back. The key phrase is that the buyer must have the minimum down from his own resources, the idea being that the buyer has some “skin in the game” so to speak. The cash-back undermined that policy. Of course, alternate borrowing methods can be used to comply with the requirement. A person can borrow the money through an unsecured line of credit, provided the buyer qualifies to carry both the debt and other loans, plus and the mortgage.
Was the cash-back a good idea? Aside from requiring an excellent credit rating from the borrower, the interest rate on the mortgage was the posted (or higher) rate, not the discount rate. So if the posted rate is 4.64% and the discount rate is 2.69%, here is the difference in interest payments on a 5 year fixed mortgage amortized over 25-years:
Purchase Price $250,000;
95% Mortgage: $237,500; Down payment:: $12,500.
Total Mortgage with 3.60% Insurance added: $246,050.
Interest Payment at 4.64%: $53,332.77
Interest Payment at 2.69%: $30,531.22
Additional Interest paid with cash-back: $22,801.55
Not the Solution if was cracked up to be after all. With a 5% cash-back and the mandatory posted rate, the borrower ended up paying $22,801.55 more in interest compared to qualifying for the discount rate with no cash-back. Had the buyer qualified and borrowed the 5% down by way of an unsecured line of credit, he/she would potentially be eligible for the discount rate, paying far less interest over the 5-year term of the mortgage.