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Lender Credit: What You Need to Know

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If you’re a homebuyer on a tight budget, your loan officer may suggest you choose an interest rate that comes with a lender credit to help offset your closing costs. The catch: The credit usually comes with a higher interest rate.

A mortgage lender credit may be worth it if you’re short on cash, though you’ll want to consider the drawbacks, too.

What is a lender credit?

A lender credit is a cash credit you receive from your lender at closing to cover some or all of your mortgage costs. Lender credits can reduce the amount of upfront cash you need to buy or refinance a home and they’re commonly associated with no-closing-cost mortgages.

But despite the association, lender credits don’t cause closing costs to vanish. Instead, your lender will pay them, then charge you a higher interest rate for the life of the loan. That, in turn, will up your monthly mortgage payment.

Lender credit limitations

A lender credit can’t be used for the following:

  • A down payment
  • The cash reserves needed to prove you have the means to pay your mortgage if you lose your income
  • The funds needed to pay off debt in order to qualify for a mortgage

How lender credits work

While lender credits are tied to your interest rate, there’s no set formula for lender credits. Lenders generally offer interest rates with three different types of pricing: par, above par and below par.

  • Par pricing. This is an interest rate that doesn’t offer lender credits or charge discount points in exchange for a lower rate.
  • Above-par pricing. This type of pricing pays a lender a premium that’s usually passed on to you in the form of a lender credit at a higher interest rate.
  • Below-par pricing. This kind of pricing costs the lender money that’s passed on to you and charged as a discount point for a lower interest rate.

The example below shows how lender credits might affect both your closing costs and monthly mortgage payments if you were to take out a $250,000 loan with a 20% down payment and an estimated $5,000 in closing costs. We’ll start with an interest par rate of 3.25% and assume that for every quarter of a percentage point higher in interest rate, your lender will apply 1% of your loan amount toward closing costs.

Interest rateMonthly principal and interest paymentLender creditClosing costs due after lender credit
3.25%$1,088.02$0.00$5,000
3.5%$1,122.61($2,500)$2,500
3.75%$1,157.79($5,000)$0.00

As you can see from the table above, lender credits require the need to weigh short-term financial perks against the long-term costs of a mortgage. Here’s the math:

Short-term benefits for a 3.25% rate loan with no lender credits:

  • You save $2,500 at the closing table for a 3.5% interest rate.
  • You save $5,000 at the closing table for a 3.75% interest rate.
  • Your payment increases $34.59 per month for a 3.50% rate.
  • Your payment increases $69.77 per month for a 3.75% rate.

Long-term costs for a 3.25% rate loan and no lender credit:

  • You’ll pay $12,454.53 more in interest over the life of the 3.50% loan.
  • You’ll pay $25,118.34 more in interest over the life of the 3.75% loan.

Your lender credit will show up as a negative number on page 2, section J of your loan estimate (LE) or closing disclosure (CD). For example, if you choose the 3.75% rate above, you’ll see a -$5,000 lender credit on your LE, reducing the closing costs you owe to zero.

Pros and cons of lender credits

ProsCons
  • More cash in your pocket at closing time
  • Reduces the time it takes to recoup your costs
  • Potential to claim the mortgage interest deduction on your taxes because your rate is now higher
  • Potential to free up money for a larger down payment
  • May lead to a higher interest rate and monthly payment for the life of the loan
  • More interest due over the life of your loan
  • May make it harder to qualify for a mortgage that requires a higher monthly payment
  • May require shopping around to receive the best lender credit options

How to negotiate a lender credit

Lender credits vary from lender to lender. The loan program you choose, as well as mortgage market conditions, can also affect lender credit rates. Because there’s no specific formula for tying interest rates to lender credits, you should compare rates from three to five lenders to see which offers the most credit for the lowest rate.

Lender credits vs discount points

Think of a lender credit as the opposite of paying mortgage points in order to get a lower interest rate. With points, you pay an upfront fee to reduce your rate, but with lender credits a lender fronts your closing costs in exchange for a rate bump.

Mortgage points make sense if you’re planning to stay in your home for the long haul and have the funds to cover the extra costs. If you’re planning on staying just a few years — or if you’re trying to maximize the equity you hope to tap with a cash-out refinance — lender credits might be worth considering.

Are lender credits worth it?

Lender credits are worth noting if you don’t have the cash to pay closing costs for a home purchase or refinance. If you’re doing a cash-out refinance, lender credits can also help you pocket extra cash to pay off high-interest rate credit cards or finish a home improvement project.

A lender credit also might make sense for:

  • First-time homebuyers who want emergency cash on hand. Many financial planners recommend having a rainy-day fund to cover three to six months of living expenses.
  • Setting up a repair and maintenance fund. Insurance experts suggest setting aside at least 1% of your home’s value to cover maintenance costs or to pay for a major repair like a roof leak or replacing an air conditioning system.
  • Covering the costs of FHA streamline refinancing. If you already have an FHA loan, an FHA streamline loan can help you refinance with less paperwork. However, this type of loan doesn’t allow you to roll closing costs into the loan amount. If closing costs are a concern, ask to see if your lender also offers a no-cost FHA streamline option to cover the costs in exchange for a higher interest rate.
  • Paying off high-interest revolving debt. If you’re coming up short on funds to pay off maxed-out credit cards with a cash-out refinance, a lender credit might help you pay off the revolving debt more quickly.
  • Keeping money on hand to meet a lender reserve requirement. Some loans require borrowers to have mortgage reserves — extra cash on hand to make several monthly mortgage payments in the event of an emergency. Extra funds in a bank account lessen the chances of a mortgage denial.

Lender credits offer one more important benefit: They can help shorten the break-even point (the time it takes to recoup your mortgage costs) on a purchase or refinance. This is especially important if you’re refinancing a home you intend to sell within the next two years.

The table below will let you compare the break-even points for a refinance loan where the current rate is 4.25% and the loan balance is $250,000. The options: a 3.25% interest rate with $5,000 in upfront, out-of-pocket closing costs versus a no-cost refinance rate of 3.75% with a $5,000 lender credit. With the 3.25% rate rate, the break-even point is 35 months, so this loan option wouldn’t make sense if you plan to sell your home in two years. The higher-interest loan, however, lets you save $72 per month, for a yearly savings of $864.

Monthly payment at 4.25%$1,230Monthly payment at 4.25%$1,230
Monthly payment at 3.25%$1,088Monthly payment at 3.75%$1,158
Monthly payment at 4.25%$1,230Monthly payment at 4.25%$1,230
Monthly savings$142.00Monthly savings$72.00
Total out-of-pocket closing costs $5,000Total out-of-pocket closing costs$0
Break-even point35 months ($5,000/$142 =35 months)Break-even pointNone. The savings starts with your first mortgage payment

Lender credit alternatives: Other ways to reduce closing costs

A lender credit is just one way to slash closing costs. It might pay to also consider these options:

  • Apply for closing cost assistance. Some state and local housing agencies offer down payment assistance (DPA) programs that also help with closing costs if you meet certain income and neighborhood requirements.
  • Ask the seller to pay your closing costs. Most home loans allow sellers to pay closing costs on behalf of borrowers. For example, with an FHA loan, a seller can pay up to 6% of your FHA closing costs.
  • Ask a relative for a gift to cover closing costs. If you have a family member or friend willing to help, many loan programs allow a donor gift to cover closing costs.
 

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