What happens after closing? You start making your mortgage payments, pay your property charges, and so on. Do you have enough funds to cover these expenses in case something unexpected happens? These “leftover funds” are called financial reserves.
Lenders will look into these funds to determine if you have enough set aside before they approve your mortgage. As to the minimum level of reserves required, that will depend primarily on your loan type, property, and borrower profile.
What Are Reserves?
Reserves are assets that are available to you post-mortgage closing. By available, these assets must be readily convertible to cash for your use, per Fannie Mae, who together with Freddie Mac, is the largest purchaser of mortgages in the secondary market.
To make them more relatable, think of these funds as x months’ worth of your total housing expenses as represented by PITI or PITIA:
- Principal
- Interest
- Taxes
- Insurance (homeowners insurance, mortgage insurance)
- Homeowners association dues, other assessments
While they are not as popularly discussed as down payment and closing costs, reserves are an important aspect of your mortgage that you should prepare for, save up if you must.
Eligible or Not Eligible Assets for Reserves
Not all assets are eligible to be considered as reserves. Aside from being liquid assets, they must be redeemed/vested, taken from personal bank accounts, or derived from the sale of an asset.
Aside from cash, these are acceptable sources of reserve funds:
(i) savings/checking accounts, (ii) stocks, bonds, certificates of deposits, trust accounts, or any investments, (iii) the portion of the retirement savings account that has vested, and (iv) the cash value of a vested life insurance policy.
As to retirement accounts, not all of the whole vested amount will be considered, e.g. 70% of 401(k), IRA and other related accounts’ vested value.
Stock units become unacceptable if they are from a company or corporation not listed with the SEC. This applies to stock options and restricted stock units that have not vested.
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You can’t also use personal unsecured loans or proceeds from cash-out refinance for your reserve funds.
This is why lenders verify assets for reserve requirements (although this asset verification applies to down payment and closing costs) to ensure that the borrower has funds safely tucked in and that these funds are not illegally sourced or additionally burdensome to the borrower.
How Much Do You Need for Your Reserves?
Your minimum reserve requirement rests on a combination of various factors. But a good starting point would be the property type, i.e. its occupancy status and the number of units.
From there, you can look up what each loan type’s reserve requirement is:
- FHA loans: This loan program does not have a reserve requirement on one-to-two properties. But for borrowers with non-traditional credit or those requiring manual underwriting, one month of reserves is required. On three-to-four unit properties, reserves worth three months of PITI are required.
- VA loans: Just like FHA loans, these loans for military personnel require (i) no reserves on one-to-two unit properties and (ii) six months’ reserves on three-to-four unit properties. The borrower also pays additional three months of reserves for every rental property he or she owns.
- USDA loans: Although these government-guaranteed loans don’t really require cash reserves after closing, having two months of reserves can be a compensating factor.
- Conforming Loans: The reserve requirements for Fannie Mae take into account the transaction type, the property’s number of units, the borrower’s credit score and LTV, and debt-to-income ratio, the type of underwriting (DU or manual). This is an example of Freddie Mac’s reserve requirements matrix.
- Jumbo Loans: Reserves on those loans can be equal to three months, although they can go higher depending on the size of the loan.
Indeed, buying a home goes beyond closing. There’s your house to take care of after the transaction closes. Despite reserves being a requirement, it’s wise to have funds set aside for your home.
If you took a survey of adults that still lived with their parents, you would probably find that a majority of them do so because of the lack of savings they possess. Without a down payment, they assume that they cannot purchase a home and they don’t want to waste money on rent, so they remain content on their parent’s couch. The good news is that there are plenty of ways to purchase a home with little to no down payment – you just have to know your options!