Mortgage Q&A: “What is a lender credit?”
How a Lender Credit Works
- Mortgage lenders know you don’t want to pay any fees to get a home loan
- So they offer “credits” that offset the customary closing costs associated with a mortgage
- These credits can be applied to things like title insurance, appraisal fees, and so on
- While you don’t pay those costs out-of-pocket, you do wind up with a higher mortgage rate, all else being equal
Everyone wants something for free, whether it’s a sandwich or a mortgage.
Unfortunately, those items cost money, and one way or another you’re going to have to pay the price as the consumer.
When you take out a mortgage, there are lots of costs involved. You have to pay for things like title insurance, escrow fees, appraisal fees, credit reports, taxes, insurance, and so on.
Lenders understand this, which is why they offer credits to cover many of these costs, reducing your burden and making their offer appear a lot more attractive.
However, when you select a mortgage that offers a credit, understand that the interest rate is higher than it otherwise would be because it absorbs those obligatory costs.
Simply put, you pay less money upfront to get your loan, but more over time.
What Can a Lender Credit Be Used For?
- You can use a lender credit to pay virtually all closing costs
- Including third-party fees such as title insurance and escrow fees
- Along with prepaid items like property taxes and homeowners insurance
When you purchase a home or refinance an existing mortgage, lots of hands touch your loan. As such, you’ll be hit with this fee and that fee.
You need to pay title insurance companies, escrow companies, couriers, notaries, appraisers, and on and on.
In fact, closing costs alone, not including down payment, could amount to tens of thousands of dollars or more.
To eliminate all or some of these fees, a lender credit can be used to cover common third-party fees such as a home appraisal and title insurance, along with prepaid items including homeowner’s insurance and property taxes.
But remember, while you don’t have to pay these fees at closing, they are still paid for by you. Just over time as opposed to at closing out-of-pocket.
Lender Credit Limitations
- A lender credit can’t be used toward down payment on a home purchase
- Nor can it be used for reserves or minimum borrower contribution
- But the credit may reduce the total cash to close
- Making it easier to come up with funds needed for down payment
While a lender credit can in fact greatly reduce or eliminate all of your closing costs when refinancing, the same may not be true when it involves a home purchase.
Why? Because a lender credit can’t be used for the down payment, nor can it be used for reserves or to satisfy minimum borrower contribution requirements.
So if you’re buying a home, you’ll still need to provide the down payment with your own funds or via gift funds if acceptable.
The good news is the lender credit should still reduce your total closing costs, so if you owed $10,000 in closing costs plus a $25,000 down payment, you’d maybe only need to come up with $25,000 total, as opposed to $35,000.
Indirectly, the lender credit can make it easier to come up with the down payment since it can cover all those third-party fees and prepaid items like taxes and insurance.
It can also make things a little more manageable if you have more money in your pocket as you juggle two housing payments, pay movers, buy furniture, and so on.
Lastly, note that if the lender credit exceeds closing costs, any excess may be left on the table, so you’ll want to choose an appropriate lender credit amount that doesn’t increase your interest rate unnecessarily.
If there is money left over, it may be possible to use it to lower the outstanding loan balance via a principal curtailment. This depends on the lender’s policy.
Borrower-Paid vs. Lender-Paid Compensation?
- First determine the type of compensation you’re paying the originator
- Which will be either borrower- or lender-paid
- Then check your paperwork to see if a lender credit is being applied
- To cover some or all of your mortgage closing costs
But wait, there’s more! Back before the mortgage crisis reared its ugly head, it was quite common for loan officers and mortgage brokers to get paid twice for originating a single home loan.
Clearly this didn’t sit well with financial 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.
Nowadays, commissioned 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 bank essentially provides a loan originator with “X” percent of the loan amount as their commission.
This way they don’t have to charge the borrower directly, something that might turn off the customer, or simply be unaffordable.
So a loan officer or mortgage broker may receive 1.5% of the loan amount from the lender for originating the loan.
On a $500,000 loan, we’re talking $7,500 in commission, not too shabby, right? However, in doing so, they’re sticking the borrower with a higher mortgage rate.
While the commission isn’t paid directly by the borrower, it is absorbed monthly for the life of the loan via a higher mortgage payment.
Simply put, a mortgage with lender-paid compensation will come with a higher-than-market interest rate, all else being equal.
On top of this, the lender can also offer a credit for closing costs, which again, isn’t paid by the borrower out-of-pocket when the loan funds.
Unfortunately, it too will increase the interest rate the homeowner ultimately receives.
The good news is they might not have to pay any settlement costs at closing, helpful if they happen to be cash poor.
This is the essential tradeoff of a lender credit. It’s not free money. In reality, it’s more of a save today, pay tomorrow situation.
An 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 a lender credit: 4%
Let’s pretend the loan amount is $500,000. The monthly principal and interest payment is as follows:
- $2,245.22 at 3.5% ($11,500 in closing costs)
- $2,315.58 at 3.75% ($4,000 in closing costs)
- $2,387.08 at 4% ($0 in closing costs)
As you can see, by electing to pay nothing at closing, you’ll pay more each month you hold the mortgage because your mortgage rate will be higher.
A borrower who selects the 4% interest rate with the lender credit will pay $2,387.08 per month and pay no closing costs.
That’s about $72 more per month than the borrower who goes with the 3.75% rate and pays $4,000 in closing costs, and roughly $142 more than the borrower who takes the 3.5% rate and pays nothing at closing.
So the longer you keep the loan, the more you pay. Over time, you could wind up paying more than you would have had you just paid these costs upfront.
But if you only keep the loan for a short period of time, it could actually be advantageous to take the higher interest rate and lender credit.
Alternatively, you could shop around until you find the best of both worlds, a low interest rate and limited/no fees.
A Lender Credit Will Raise Your Mortgage Rate
- While a lender credit can be helpful if you’re cash poor
- By reducing or eliminating all out-of-pocket closing costs
- It will increase your mortgage interest rate as a result
- You still pay those costs, just indirectly over the life of the loan as opposed to upfront
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 their work on 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.
If the borrower elects to use a “lender credit” to cover those costs, it may bump the interest rate up another quarter percent to 4%. But they can refinance for “free.” This is known as a no closing cost loan.
In other words, the lender increases the interest rate twice. Once to pay out their commission, and a second time to cover closing costs.
While the interest rate is higher, the borrower doesn’t have to worry about paying the lender for taking out the loan, nor do they need to part with any money for things like the appraisal, title insurance, and so on.
Check Your Loan Estimate Form for a Lender Credit
- Take a good look at your LE form when shopping your home loan
- First take note of the total closing costs involved
- Then see if a lender credit is being applied in your situation
- If so, determine how much it reduces your out-of-pocket expenses to see if it’s worth it
On the Loan Estimate (LE), 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…
Check the dollar amount of the credit to determine how much it’s doing to offset your loan costs.
You can ask your loan officer or broker what the mortgage rate would look like without the credit in place to compare. Or compare various different credit amounts.
As noted, the clear 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 many 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? Lender Credit or Lower Rate?
- Compare paying closing costs out-of-pocket with a lower interest rate
- Versus paying less upfront but getting saddled with a higher interest rate
- If you take the time to shop around with different lenders
- You might be able to get a low interest rate with a lender credit!
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.
You could save a ton in interest long-term by going with a lower rate if you hold onto your mortgage for decades.
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.
For instance, if you take out an adjustable-rate mortgage and doubt you’ll keep it past its first adjustment date, a credit for closing costs might be an obvious winner.
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 temporarily.
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 credit is the better deal, and vice versa. But if you take the time to shop around, you should be able to find a competitive rate with a lender credit!
Read more: What mortgage rate should I expect?