Cash Reserves on Mortgage Loans Can Trip Up Borrowers

Piggy BankSome mortgage lenders are requiring more cash reserves today than they did in the past. It’s part of the less-risk mentality adopted in the wake of the housing crash.

For borrowers, it means one more hoop to jump through when qualifying for a mortgage. And for a rising number of home buyers, it can be a painful lesson in mortgage rejection.

What are Cash Reserves?

The term “cash reserves” refers to extra money the borrower has in the bank on closing day. These funds go above and beyond what is needed for the down payment and closing costs. Some lenders have cash-reserve requirements on top of all their other mortgage criteria (credit scores, debt ratios, etc.). It’s not always mentioned up front either. So buyers need to be proactive and ask about these requirements when applying for a loan.

Here’s an example of cash reserves in action:

I’m getting a mortgage loan for $350,000. My monthly payments come out to $2,242. If a lender has a two-month cash-reserve requirement, I must have an additional $4,484 in the bank before closing. This is on top of whatever down payment and closing costs I have to pay.

If the lender required six months worth of reserves (as some of them do these days), I would need $13,452 in the bank before I could close. This is a closing requirement, but not a closing cost. I don’t have to pay this money when I close on the loan. I just need to have it in the bank. So it still puts a financial burden on me, as a borrower. It makes it harder to qualify for the loan.

Why Do Lenders Require Them

Cash-reserve requirements are intended to provide a safety cushion in case the borrower suffers a financial setback (such as the loss of a job). With extra money in the bank, the homeowner would be able to cover his or her mortgage payments for a few months. So it’s basically a foreclosure-avoidance strategy.

But there’s a major flaw with the concept of cash reserves. In theory, the borrower could spend that extra money two days after closing. It wouldn’t be the smartest move, but there’s really nothing to prevent it from happening. The money does not sit in an escrow account managed by a third party. It sits in the borrower’s bank account, where it’s totally accessible. So the lender has no assurance the borrower will keep the money to serve as a safety net (which is the intended purposes of cash reserves).

More Prevalent in Wake of Housing Crash

Cash reserves are nothing new. They’ve been around as long as the lending industry itself. But two things have changed over the last few years. More lenders are requiring them today, and the amounts have gone up in many cases.

At the height of the housing bubble, few mortgage lenders required cash reserves. Back then they didn’t require much more than a job, a pulse and a Social Security Number. Times have sure changed.

Today, more and more lenders are requiring cash reserves. This is true even when a particular loan program doesn’t have reserve requirements. For example, VA loans do not require any cash reserves. But some lenders will impose their own requirements on top of the VA’s minimum guidelines. In the lending industry, these are known as overlays. So they might tell you up front there are no cash-reserve requirements on a particular loan, and then later the underwriter comes back and says there are.

Or they might disclose them in advance. Either way, the end result is the same. You need to have extra money in the bank if you want to close the loan.

Mortgage lenders are also requiring larger amounts of reserves, especially for bigger loans. The average requirement for conventional mortgage loans (among those lenders that require cash reserves) is two months’ worth. This means the borrower must have the cash equivalent of two months of mortgage payments in the bank, before closing. Some lenders are even requiring six months worth of reserves.

This puts up a major hurdle for some borrowers. In some cases, it will kill the deal even when the borrower passes all of the other requirements with flying colors.

Well-Qualified Borrowers Being Rejected

In some cases, borrowers don’t learn about cash-reserve requirements until after they’ve applied for the loan. That was the case for Brad and Melinda, a pair of veteran home buyers in Carlsbad, California. They applied for a VA loan through Bank of America. Cash reserves were not mentioned up front. But it brought the mortgage process to a screeching halt just days before closing.

“We specifically asked them about it when we applied for the loan,” Melinda explained. “We knew a lot of lenders were requiring cash reserves these days, so we asked them point-blank. The loan officer told us no, there aren’t any cash-reserve requirements for VA loans. We moved forward based on that.”

Both borrowers had excellent credit scores above 800. They also had a flawless, ten-year history of paying their debts on time. They had more than sufficient funds to cover their closing costs and down payment. They were, by most standards, well-qualified borrowers.

Five days before their scheduled closing date, the loan underwriter raised a red flag and put the process on hold. At first, he said the borrowers would need two months worth of cash reserves to close the loan.

“We were surprised by this, since we had asked about it in advance,” said Melinda. “But we figured it was still do-able. We had some extra funds in the bank, aside from our down payment and closing costs.”

The next person the borrowers heard from was their loan officer, the same person who had originally told them that cash reserves weren’t necessary.

“The loan officer came back and said, ‘the underwriter now says you need six months of cash reserves in the bank, before closing.’ That’s $20,000 we hadn’t accounted for up front, based on the loan officer’s original statement. There was no way we could pull that kind of money out of thin air.”

At the time of publication, Brad and Melinda were in the process of switching lenders. They found another lender who did not require any reserves on VA loans.

“Frankly, he was scratching his head over the whole thing,” Melinda added. “He looked at our credit scores and other qualifications, and could not imagine why BofA would require so much money in reserves. I guess it’s true what they say. It pays to shop around.”