What are Cash Reserves and Why to Lenders Require Them?

Of all of the underwriting requirements for a mortgage, it’s a good bet you’ve never heard of the term cash reserves. But this is a common lender requirement, that many would-be homeowners don’t learn about until they make an application for a mortgage.

The complication is that while you are saving up money for the down payment on a house, plus any required closing costs, the cash reserve requirement could end up increasing the amount of money that you need to come up with.

What are Cash Reserves?

When a lender approves your mortgage, they naturally want to be reasonably sure that you will be able to afford to keep the home and make the payments. One of the way that they do this by requiring that you have extra money available after you close on the new loan. This is where cash reserves come into the picture.

Cash reserves are typically expressed in a certain number of months of your house payment. Your house payment has three major components:

• Principal and Interest on the loan itself commonly referred to as “P&I.”
• Taxes, as in the monthly allocation of your real estate taxes
• Insurance, which is represented by the monthly allocation of your homeowner’s insurance, private mortgage insurance (if required), and other types of housing-related insurance, such as flood insurance or earthquake insurance

Together, these three components represent your “PITI,” or Principal, Interest, Taxes and Insurance.

The cash reserve requirement will be based on a certain number of months of PITI. So for example, if your monthly PITI is $1,500, and the cash reserve requirement is for two months reserves, then you will be required to document that you will have at least $3,000 in liquid assets remaining after the closing to cover the reserve requirement.

Why Lenders Require Cash Reserves

One of the biggest problems for mortgage lenders is what is known as early term defaults. That’s when a borrower defaults on a mortgage within months of closing on the home. Since lenders require that a mortgage be outstanding for at least two years before they even break even on the loan, an early term default represents an out-of-pocket loss to the lender.

Lenders tried to mitigate this risk through careful consideration of your ability to make the house payment based on your income and credit standing. But one of the best ways to prevent early term default is to make sure that you have some cash left over after the closing. Since new homeowners are typically most vulnerable in the months following the closing, the availability of liquid cash reduces the likelihood of a missed payment, that could spiral into an outright default.

Important: Cash reserves are liquid assets that belong to you. They are not an extra charge or even an escrow that is held by the lender. You merely need to show that they exist before closing. What you do with that money afterward is completely up to you. It’s simply a precaution that lenders take to reduce the risk of early term default.

Typical Cash Reserve Requirements

The actual cash reserve requirement varies based on the type of property that you are purchasing or refinancing.

Typical cash reserve requirements look like this:

• Owner occupied primary residence, no cash reserves required but can go up to six months depending on your credit profile
• Owner occupied primary residence, 2-4 family homes may require additional reserves
• Vacation homes, two months cash reserves, though they can go up to 12 months based on your credit profile
• Investment properties, six months, but can be higher based on your credit profile

If you own additional financed properties, the lender will also require the above cash reserves, plus a percentage of the amount of money owed on the other properties.

For example, if you are purchasing an investment property, the lender will require six months cash reserves on that property. But if you also own six other investment properties, all of which are financed, the lender will also require that you have additional cash reserves equal to 4% of the amount of indebtedness on those other investment properties.

Let’s say that you own six other properties, all of which are financed for a total of $600,000. You apply for a mortgage to buy a seventh investment property. The lender will require six months of cash reserves on the new property, plus $24,000 ($600,000 X 4%) in reserves for the other properties.

How the Lender Will Want You to Document Cash Reserves

Lenders will typically want you to provide documentation for your cash reserves in the same way that you will need to prove that you have sufficient funds to cover the downpayment and closing costs. This will typically include copies of statements covering the most recent two-month period, or a formal Verification of Deposit form sent by the lender to the depository, to be completed and returned to the lender.

Acceptable sources of cash reserves include:

• Checking and savings accounts
• Investments, such as stocks, bonds, mutual funds, certificates of deposit, money market funds, and trust accounts
• The vested balance in your retirement savings
• The cash value of a life insurance policy

Conversely, some of the sources of cash reserves that are considered to be unacceptable include:

• Funds that are not vested
• Funds that cannot be withdrawn under circumstances other than the account owner’s retirement, termination of employment, or death
• Stocks held in an unlisted corporation
• Non-vested stock options and non-vested restricted stock
• Personal unsecured loans
• “Interested party” contributions – that means that somebody who has a direct interest in your loan closing cannot provide you with the funds for cash reserves. This includes real estate agents, mortgage brokers, builders, attorneys, or the sellers of the property that you are purchasing
• Cash proceeds from a cash refinance transaction on the property that you are financing

Basically, cash reserves must be your own money, and not be either provided by a third party (for the purpose of enabling you to meet the requirement) and not be restricted in any way. That will make them available to meet contingencies after the closing on your loan.

Why Having Cash Reserves are in Your Best Interests

Apart from the fact that cash reserves are a lender requirement, it really is in your best interests to have them.

One of the most financially dangerous moves that you can make is to close on a large loan obligation without having any liquid cash available after the fact. In addition to the fact that you might find yourself cash-short in any given month after the closing, there’s also the fact that purchasing a new home almost always carries the prospect of unexpected expenses.

For example, once you move into the home, there may be unexpected repairs needed. As well, you may need certain equipment to maintain the property, such as a lawnmower or a snowblower.

Then there are expected expenses, such as furniture and decorations. If you close on the home without having any extra cash, you may find yourself unable to afford these extras, especially in light of the new house payment.

So if you run into a lender requirement for cash reserves, don’t fight it – embrace it! It really is for your own good.