Mortgage Q&A: “What is a lender credit?”
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.
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
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 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 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 essentially the 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 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 now, you’ll pay more each month you hold the mortgage.
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.
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, 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 .25% 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
- To first determine the total closing costs
- Then to see if a lender credit is being applied
- And if so, how much it reduces your out-of-pocket expenses
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?
- 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 and 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?