Mortgage Q&A: “What is a lender credit?”
Clearly this didn’t sit well with regulators, so in light of this perceived injustice to borrowers, changes were made that essentially limited a loan originator to getting just one form of compensation.
Borrower-Paid vs. Lender-Paid Compensation
Nowadays, loan originators must choose either borrower or lender compensation (it cannot be split), with many opting for lender compensation as a means to keep a borrower’s out-of-pocket costs low.
With lender-paid compensation, the lender essentially provides a loan originator with “X” percent of the loan amount as commission.
So a mortgage broker may receive 2% of the loan amount from the lender for handling the loan. However, in doing so, they are sticking the borrower with a higher mortgage rate. This is the tradeoff.
In other words, a mortgage with lender-paid compensation will come with a higher-than-market interest rate, all else being equal.
Quick example of a lender credit:
Loan type: 30-year fixed
Par rate: 3.5%
Rate with lender-paid compensation: 3.75%
Rate with lender-paid compensation and lender credit: 4%
As you can see, in the scenario above the borrower actually qualifies for a par mortgage rate of 3.5%. However, they are offered a rate of 4%, which allows the loan originator to get paid for handling the loan, and provides the borrower with a credit toward their closing costs.
The loan originator’s lender-paid compensation may have pushed the interest rate up to 3.75%, but there are still closing costs to consider. They may bump the interest rate further to 4%, using a “lender credit” to cover those costs so the borrower can refinance for “free.” This is known as a no closing cost loan.
In other words, the loan originator increases the interest rate twice. Once for their commission, and a second time to cover closing costs.
On the Good Faith Estimate, you should see a line detailing the lender credit that says, “this credit reduces your settlement charges.” It’s a shame it doesn’t also say that it “increases your rate.” But what can you do…
The obvious benefit is avoiding out-of-pocket expenses, which is important if a borrower doesn’t have a lot of extra cash on hand, or simply doesn’t want to spend it on refinancing their mortgage.
It also makes sense if the interest rate is pretty similar to one where the borrower must pay both the closing costs and commission.
For instance, there may be a situation where the mortgage rate is 3.5% with the borrower paying all the closing costs and commission, as opposed to 3.75% with all fees paid thanks to the borrower receiving a lender credit.
That’s a relatively small difference in rate, and the upfront closing costs for taking on the slightly lower rate likely wouldn’t be recouped for years.
Of course, it should be noted that the larger the loan amount, the larger the credit, and vice versa, seeing that it’s represented as a percentage of the loan amount.
So those with small loans might find that a credit doesn’t go very far, or that it takes quite a large credit to offset closing costs. Meanwhile, someone with a large loan might be able to eliminate all closing costs with a relatively small credit (percentage-wise).
In the case of borrower-paid compensation, the borrower pays the loan originator’s commission instead of the lender. The benefit here is that the borrower can secure the lowest possible interest rate, but it means they generally pay out-of-pocket to obtain it.
They can still offset some (or all) of their closing costs with a lender credit, but that too will come with a higher interest rate. However, the credit can’t be used to cover loan originator compensation.
If you go with borrower-paid compensation and don’t want to pay for it out-of-pocket, you can use seller contributions to cover their commission (since it’s your money) and a lender credit for other closing costs.
Which Is the Better Deal?
There are clearly a lot of possibilities here, so take the time to see if borrower-paid compensation will save you some money over lender-paid compensation, with various credits factored in.
Generally, if you plan to stay in the home (and with the mortgage) for a long period of time, it’s okay to pay for your closing costs out-of-pocket and even pay for a lower rate via discount points. You could save a ton in interest long-term by going with a lower rate.
But if you plan to move or refinance in a relatively short period of time, a loan with a lender credit may be the best deal.
You won’t have to pay much (if anything) for taking out the loan, and you’ll only be stuck with a slightly higher interest rate and corresponding mortgage payment.
As a rule of thumb, those looking to aggressively pay down their mortgage will not want to use a lender credit, while those who want to keep more cash on hand should consider one.
There will be cases when a loan with the lender credit is the better deal, and vice versa. So shop around! You should be able to find a competitive rate with a lender credit.
Read more: What mortgage rate should I expect?