What are mortgage reserves and how much do you need?

Setting aside cash for a down payment and closing costs is an important part of preparing to buy a home, but these two expenses are not the only requirements you need to think about. You might also need something called mortgage reserves.

Don’t panic — it’s really a fancy term for savings. It simply means that, if you are borrowing money to buy a home, your lender may want to see a healthy bank or investment account or other liquid assets that you can use to make mortgage payments, as backup to your salary or wages. Having a cash reserve shows lenders you will be able cover your mortgage should there be any changes in your earned income or an emergency.

Not every borrower will need mortgage reserves.  Let’s look at when this requirement for additional funds for mortgage payments might apply to you.

What are mortgage reserves?

Reserves for mortgage loans are assets that you have easy access to if you were to need help covering your mortgage payments. These assets are money you have left over after you make a down payment and pay closing costs.

Reserves are measured in months. If you had $7,200 in a savings account after you close on your loan, for example, and your monthly mortgage payment is $1,800, you’d have four months’ cash reserve.

What assets are allowed as mortgage reserves?

Reserves aren’t limited to cash in your bank accounts. There are other types of assets that qualify as reserve funds for mortgage loans, including:

• Vested funds in retirement accounts, such as a 401(k) or Roth IRA
• Stocks, bonds, mutual funds and money market funds
• Certificates of deposit (CDs)
• Cash value of an insurance policy
• Funds in a trust

What assets aren’t allowed as mortgage reserves?

Some examples of assets that are not allowed to count toward the reserves mortgage lenders may require include:

• Funds that aren’t yet entirely vested
• Funds that can only be withdrawn upon retirement or termination of employment
• Unsecured loans (e.g., personal loans)
• Money obtained through a cash-out refinance

Typically, when it comes to reserves for mortgage loans, lenders like to see what’s known as liquid or near-liquid assets. Translation: The assets — if not cash themselves — can easily be sold and turned into cash if need be.

Such readily accessed funds can range from a bank account balance that you simply write a check on to cash to withdrawals from a fully vested workplace retirement plan — meaning the money in the account belongs to you entirely, not to your employer.

When do you need reserves?

Most borrowers don’t need a cash reserve or other reserve funds for mortgage loans unless they’re buying a certain type of property or their application could use a boost due to poor credit, a low down payment or a high debt-to-income (DTI) ratio.

Homebuyers with a credit score below 700 who are making a down payment of less than 20 percent, for instance, might need to have six months in financial reserves available to get approved.

Even homebuyers making a more substantial down payment may still need to have mortgage reserves if their credit score is in the 600s. In such cases, you might need enough reserves for mortgage payments for two to six months. The self-employed might also need to demonstrate reserves, especially if they don’t have steady paychecks or a regular income stream.

If you’re a real estate investor, you might need to have cash reserves mortgage lenders can see, as well — particularly if your repayment plans are based on income (rents or leases) generated by the property you’re borrowing against.

How much are mortgage reserves?

The amount you need in mortgage reserves can vary, depending on the type of loan you’re applying for and the kind of property you’re buying.

Mortgage reserve requirements by loan type

Mortgage reserve requirements by property type (generally)

“Multi-unit properties require more reserves, as do investment properties,” says John Stearns, senior mortgage loan originator at American Fidelity Mortgage Services in Wheaton, Illinois. “The reserves will be based on how much borrowers owe on these investment properties.”

How to build your mortgage reserves

1. Cut down on spending

Look at your budget and see if you can cut back spending anywhere. You can cancel some subscription-based services you don’t use a lot, for example, shop smarter at the grocery store or find a cheaper provider for your car insurance.

2. Set aside a portion of income

Since your savings accounts qualify as reserves, you can augment these by putting aside some of your income in these accounts each month. Consider setting up automatic deposits to make it even easier to stash money away.

3. Consider a CD

If the interest rate on your savings account isn’t cutting it and you’re several months away from getting a mortgage, consider a certificate of deposit (CD) to build your reserves for mortgage payments. CDs are an acceptable reserve asset, and CD rates tend to be higher than savings account rates, giving you a better return.

4. Move into the money markets

Offered by banks and credit unions, a money market account (MMA) is a cross between a savings account and a checking account: You earn a competitive rate of interest on your deposited funds. MMAs tend to offer lower yields (APY) than CDs, but they are also more liquid, allowing you to withdraw money via debit cards or checks.

A similar vehicle is a money market fund, a type of mutual fund offered by brokerages and investment companies that generates income from short-term securities, at a better rate of return than savings accounts or MMAs. It too allows you to make withdrawals and ranks as a low-risk investment (though it is not insured by the FDIC, as it’s not a bank account). Bear in mind that, while highly liquid, both MMAs and money market funds may require high minimum deposits and that you maintain certain balance minimums.

5. Increase contributions to your retirement account

Vested money in 401(k) funds is a type of cash reserves mortgage lenders generally accept. If you’re only contributing the minimum to your retirement accounts, consider an increase. This is particularly important if your employer provides matching contributions. At the very least, you should contribute enough to max out your employer matching funds, which will help increase your retirement fund more quickly.

6. Save money from windfalls

If your job provides regular bonuses or you typically get a sizable refund from the IRS each year, make it a habit to set some of that money aside for your cash reserve.

Bottom line on mortgage reserves

Not all mortgage loans mandate a cash reserve — or if they do, it’s not for all borrowers. To avoid incurring it, work to save up for a bigger down payment and focus on boosting your credit score.

Even if a lender doesn’t require them, mortgage reserves are smart to have as part of the emergency fund you maintain in case of a job loss, because they help substitute for lost income. “I generally tell people to have at least six months of mortgage payments in the bank,” says Scott Sheldon, branch manager at New American Funding in Santa Rosa, California. It doesn’t have to be all in cash: “This can be money that’s cumulative across their bank, stocks, bonds and even IRA funds.”

Just chalk it up to another expense as you embark into homeownership — and all its associated costs.

Additional reporting by Kacie Goff