What are mortgage reserves?

Understanding mortgage reserves

Mortgage reserves are funds you can easily access and use to make your mortgage payments if you’re temporarily unable to use your ordinary income to do so (such as if you lose your job or fall ill). The goal of mortgage reserves is for your lender to avoid needing to foreclose on your home if you have a temporary financial hardship.

In most cases, mortgage reserves are the remaining cash you have on deposit with a financial institution after you make the down payment and cover any closing costs. These assets can include money you hold in a checking, savings, money market or certificate of deposit (CD) account.

However, other types of assets you can quickly and easily liquidate can also be considered mortgage reserves. A few examples include:

• Publicly traded stocks
• Bonds
• Mutual funds
• Cash surrender value of a life insurance policy
• Vested funds held in retirement savings accounts

Assets that can’t be quickly turned into cash aren’t acceptable mortgage reserves. For example, stock in a private corporation (e.g., your brother-in-law’s small business) wouldn’t be acceptable because it’s unknown how much the stock would sell for or how quickly it would sell. Also, stock or retirement savings that haven’t yet vested (can’t be cashed out) aren’t acceptable.

Additionally, most loan proceeds can’t be used as mortgage reserves. For instance, availability on an unsecured personal loan or credit card doesn’t qualify, as you may be unable to access these funds in a financial emergency. Similarly, funds from a cash-out refinance on your home usually aren’t acceptable mortgage reserves.

When mortgage reserves are needed

When you apply for a home mortgage, lenders evaluate various criteria to see if you qualify for the loan. Mortgage reserves are one common type of criteria.

Although the specific requirements vary by lender and the type of mortgage, lenders commonly require cash reserves to help mitigate their risk, explained Dennis Shirshikov, head of growth at Awning, a real estate company serving property owners and investors.

The amount of mortgage reserves you’ll need can depend on such things as “the type of loan, your credit score and your debt-to-income ratio,” said Shirshikov.

“Picture this: you're a lender, and you have two applicants for a mortgage. One has a solid reserve of cash set aside, and the other lives paycheck to paycheck. As a lender, you'd feel more secure lending to the applicant with reserves, right? That's essentially why reserves are required — it gives lenders that extra reassurance.”

Some factors that affect the need for mortgage reserves include:

• Credit score: Lenders may require lower or no minimum cash reserves if you have a fair-to-good credit score (e.g., 660 to 720).
• Debt-to-income (DTI) ratio: Lenders commonly require borrowers to have DTI ratios of no more than 36% to 45%. The higher your DTI ratio, the more cash reserves you may need.
• Loan-to-value (LTV) ratio: Borrowers who can make larger down payments or with more equity in their home are typically viewed as lower risk. The minimum cash reserve requirements may also be less.
• Occupancy status: If the mortgage is used to finance your primary residence, the cash reserves may be lower than to finance a second home or rental property.
• Property characteristics: If the property is a single-family residence, the minimum cash reserve requirements may be less than if you’re financing a property with two to four residential units.
• Mortgage type: Each type of mortgage has its own requirements. For example, the cash reserve requirements for conventional loans may differ from those required for a FHA or VA loan. Similarly, you might need larger cash reserves for a cash-out refinance than you would for a standard loan to purchase a home.

Ultimately, the riskier the transaction, the more cash reserves you can expect to need. The goal of cash reserves is to evaluate how long you can make your mortgage payments without using your ordinary income.

If a borrower is considered at high risk of default due to a low credit score or high DTI ratio, one way lenders mitigate this risk is by requiring more significant mortgage reserves.

How mortgage reserves work

During the mortgage pre-qualification and approval process, your lender will test how many months your liquid assets can cover your mortgage payments and related housing costs, such as insurance premiums and real estate taxes.

The number of months' worth of mortgage reserves you’ll need will depend on your loan risk. Low-risk loans may not require any reserves, whereas you might need reserves sufficient to cover your housing costs for at least two to six months for higher-risk loans.

For example:

• If you have a credit score of at least 680, your DTI ratio is 36% or less and you have at least 5% equity on your single-family home, you might not need any cash reserves.
• In the same scenario, you might need six months' reserves if your credit score is less than 660.

You don’t need to set this money aside in a separate account, and your lender won’t hold it as collateral. Instead, you’ll provide documentation during the loan approval process to verify you have enough liquid assets to meet the mortgage reserve requirements. For example, you may need to provide bank or brokerage account statements for the most recent three months.

» MORE: How to get preapproved for a mortgage

How to build your mortgage reserves

You can build your mortgage reserves using the same process as any other savings goal: Figure out how much money you need to save and how much time you have to meet your goal.

When you’re saving to buy a house, you should include in your budget funds to:

• Cover the required down payment (typically 3% to 10% of the purchase price)
• Pay for closing costs (typically 2% to 5% of the loan amount)
• Make any desired home improvements
• Buy furniture or appliances
• Build an emergency fund (including money you can use for mortgage payments)

A good rule of thumb is to build an emergency fund sufficient to fully cover at least three to six months of living expenses. This should give you a cushion above and beyond what’s required to get a mortgage.

After you’ve set your savings goal, evaluate your household budget and consider how you can adjust to get there. For example, you might try to reduce your expenses by eating at home more often. Or you could automatically put a portion of your paycheck into a savings account.

If you need help creating a savings plan, a financial counselor may be able to help you get started. Lots of banks offer these types of services for free. Plus, you may even be able to get free or low-cost financial help from a nonprofit credit counselor.

» MORE: How much house can I afford?

Bottom line

Mortgage reserves are one of many factors lenders evaluate during the loan approval process. For loans with a low risk of default, lenders may not require you to meet a minimum mortgage reserve requirement.

However, if your loan has a higher risk of default, your lender may offset some of this risk by requiring you to have enough liquid assets on hand to cover at least two to six months of your mortgage payments and related housing costs.

Not only do mortgage reserves protect your lender from potential loan losses, but these reserves can also help protect you from losing your most valuable asset to foreclosure if you experience financial hardship.