Lender Credits: Definition, Pros And Cons
When you buy a house or refinance, there are several costs to consider. Everyone thinks of the down payment or equity they need to have available to meet their goals, but many people don't account for closing costs, which can be 3% – 6% of the loan amount. If you're trying to save on costs, a lender credit may help.
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What Is A Lender Credit?
Lender credits are when a lender agrees to take on part or all a borrower’s closing costs in exchange for the client agreeing to a higher interest rate for the loan. The higher the credit, the greater the interest rate increase.
We'll get into this more later on, but the rate you get will vary depending on the size of your lender credit. This adjustment is made after accounting for things that influence your rate, such as your credit score and the size of your down payment.
Is Accepting Lender Credits A Good Idea?
Lender credits have the benefit of helping buyers with home affordability by reducing eliminating closing costs. They can also provide you an easier path to refinancing for the same reason. However, lender credits have their downsides. Check out the pros and cons before using them in your mortgage transaction.
As you read through the following sections, keep your personal situation in mind. There’s no one-size-fits-all approach. Speak with your financial advisor, if you have one, as well as our Home Loan Experts before moving forward.
Pros Of Lender Credits
There are a couple of advantages to lender credits. Let's break them down.
- Lower upfront costs: It can vary depending on the type of loan you’re getting, but closing costs are generally 3% – 6% of your loan amount. Given this, lender credits could reduce or eliminate a barrier to buying a home or refinancing your current one.
- Can potentially buy a house faster: One of the biggest obstacles to buying a home is having to come up with a down payment. However, reducing or eliminating closing costs could allow you to put more toward a down payment and get a home sooner, as long as the higher payment still leaves you with a qualifying debt-to-income ratio (DTI).
Cons Of Lender Credits
Lender credits also have their downsides. Let's talk these through.
- You’ll pay more over the life of the loan: Because your interest rate will be higher than if you hadn’t taken lender credits, you’ll pay more in costs over the life of the loan. You’re trading lower costs upfront for higher costs later on.
- Higher mortgage payments: Because your interest rate is higher, you’re going to have higher mortgage payments compared to someone with the same term with a lower rate.
- Potential for higher costs when refinancing: When you refinance your existing mortgage, you’re paying off your full mortgage balance. Because the interest rate is higher than your original loan, you might need to take a slightly higher loan balance when refinancing to pay it off, which could lead to higher closing costs.
Lender Credit Vs. Discount Points
Lender credits are the opposite of another mortgage mechanism known as discount points. Sometimes referred to as mortgage points, discount points are extra costs borrowers can pay upfront in the form of prepaid interest to lower their mortgage rate.
Almost any mortgage rate you see advertised has a certain point level tied to it. When you take a lender credit to lower your closing cost, you’re taking a rate tied to negative points. One point is equal to 1% of the loan amount. As an example of the way mortgage lenders set pricing, look at the following table of hypothetical rates:
Lenders cover some or all your closing costs when you take a negative rate. When you pay for mortgage points, you end up saving money on interest over time. Be aware of when you’re going to break even on the deal to see if it makes sense. Here’s an example of that math:
You’re getting a $200,000 home loan and you want to know when you break even by paying for 2 points to lower your payment by $50 per month.
First, multiply the loan amount by 2%. Remember, 1 point equals 1% of the balance. This comes out to $4,000 ($200,000 × 0.02). Next, divide this number by your monthly savings, $50. You’ll breakeven in 80 months ($4,000 ÷ $50), or 6 years and 8 months.
It makes sense to buy the points if you have the money and expect to stay in the house for that time without refinancing. It’ll pay off in the long run. Otherwise, don’t worry about putting extra toward closing costs and instead put it toward something else like furniture or your down payment.
Other Ways To Save On Closing Costs
If you don’t want to take a lender credit, but you’re still looking to save on closing costs, you could ask for seller concessions. Seller concessions involve a seller paying part of your closing costs. They might give this if they’re motivated to sell the house or if you’re offering them a higher price in exchange.
Another way save is if the appraised value comes in at or above the price you are offering. In this scenario, you can add the amount you’re saving in closing costs into your loan amount without paying a higher rate.
The one thing to be careful of here is that whether a seller agrees depends on the type of real estate market you’re in. Right now, in many areas across the country, there is much more demand for homes than there is supply.
According to the latest reported existing home sales, every existing home on the market would be sold within a scant 2 months and homes are only staying on the market an average of 17 days. It’s considered a balanced market if there’s 6 months’ worth of available supply. In other words, sellers can afford to be picky. Many are receiving multiple offers in a short period.
This strategy to lower closing costs tends to work better when buyers have more leverage in slower markets. This is just not the environment that exists in most major metropolitan areas right now.
The Bottom Line
Lender credits can be an effective way for those looking to buy a home or refinance to lower the closing costs associated with giving a mortgage. The strategy does have its pluses and minuses.
On one hand, you’re lowering your closing costs which could enable you to put more toward a down payment or another use. On the other, you’re opting for a higher rate and paying more over the life of the loan.
Seller concessions are one way to save money on closing costs without taking lender credits. However, it’s a seller’s market across most of the country, and many likely won’t want to pay your closing costs.
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