Every mortgage loan comes with closing costs, which can add up to thousands of dollars. This represents a significant hurdle for some borrowers, who may find it difficult to pay these various fees upfront, especially on top of a down payment.
Fortunately, there’s a way to reduce your closing costs: lender credits. With a lender credit, your lender will pay some or all of your closing costs in exchange for a higher interest rate.
Opting for lender credits has its pros and cons. Learn more about what’s involved and the long-term effects of choosing lender credits.
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Mortgage closing costs – which can include fees for loan origination, appraisal, title search and insurance, attorney costs, and more – typically equate to 2%-5% of the loan’s amount. And that’s on top of your down payment.
If you bought a $300,000 house with a conventional loan and put 3% down, you’d need $9,000 for your down payment. That means you’d be borrowing $291,000, and 2% (using the minimum estimate) of your loan would be $5,820. Between your down payment and closing costs, you would need $14,820 upfront — a hefty sum for even the most careful saver.
Many homebuyers find it challenging to pay for closing costs in a lump sum. Lender credits reduce the cash you need to close, making it easier to buy a home, if your mortgage lender offers credit.
According to the Consumer Financial Protection Bureau (CFPB), lender credits involve paying a higher interest rate in exchange for the lender giving you funds to pay for closing costs. The trade-off is that you’ll pay more in interest over the life of the loan.
“Lender credits work almost like an additional loan. Your lender or bank will pay off your upfront closing costs if you agree to monthly installment payments in the form of a higher interest rate,” said Than Merrill, founder and CEO of FortuneBuilders.com. “With this scenario, the borrower is simply deferring closing costs to a later date and spreading them out over a prolonged period, all while paying more because of the newly agreed-upon rate.”
There’s no universal lender credit program, so different lenders will have their own policies on how lender credits work for their borrowers. Depending what your lender offers, you could end up with a no-closing-cost loan, though you will pay for those costs via a higher monthly payment.
Lender credits can be a smart option for borrowers, including first-time homebuyers, who can afford a mortgage payment but struggle to save up the necessary upfront costs. But whether or not lender credits are a good deal for you will depend on how long you plan to keep the mortgage before selling your home.
If you decide to keep your loan for its full term – typically 30 years – the extra interest you will pay over that time could far surpass the amount you would have paid in upfront closing costs.
You choose to refinance or sell within three years of getting your mortgage loan. Here, because you decided to hold onto your loan for only a few years, paying a slightly higher interest rate didn’t hurt you in the long run because there was no “long run.”
Crunch the numbers
“It comes down to math. If you think that you might be moving or paying off your loan in five years or less, then you may benefit from taking the lender credit more than it will cost you in the form of a higher rate,” said Andrew Weinberg, a mortgage professional in Great Neck, New York.
Let’s take the aforementioned example in which you buy a $300,000 house with 3% down. Your loan amount is $291,000, and your closing costs are $5,820.
Assuming your interest rate is 3% and you have a 30-year fixed-rate loan, your monthly principal and interest payment would be roughly $1,227 (this example does not include property taxes and homeowners insurance). If you keep the home loan for 30 years and don’t sell or refinance, your total interest paid will be about $150,672.
But if you opt for lender credits in which the lender pays your $6,000 in closing costs and increases your interest rate to 3.125%, your monthly payment increases slightly to about $1,247. Your total interest paid over 30 years jumps to $157,766.
So, you’re paying more over the life of the loan than you would have if you paid the closing costs outright. However, if you refinanced or sold the home after three to five years, you would pay only a fraction of the total interest while still paying less upfront.
Lender credit versus discount points
There is another way to negotiate your loan costs with your mortgage lender: pay discount points.
This arrangement works in reverse from lender credits. Instead of paying a higher interest rate so that your lender can cover your closing costs, you pay more money at closing in exchange for a lower interest rate – allowing you to pay less overall interest over the life of your loan. Paying points can be a smart strategy if you intend to stick with this home for the foreseeable future.
“If a borrower could reduce his interest rate by 0.5% by paying the lender a discount fee of 1 point (which equates to 1% of the loan amount) the borrower would probably think that’s a good deal,” Weinberg said.
But the value of paying points will depend on how much the lender reduces your interest rate.
“In the end, paying points is a math question: Does it make sense to pay money today to save money in the future?” Weinberg added.
Additionally, the decision to pay for discount points or take lender credits is best determined by your current level of liquidity.
“If you can afford the closing costs without detracting too much from your savings, you should consider paying the closing costs on your own. However, if your finances are less than ideal, you may need to defer immediate costs in order to cover other more pressing issues,” Merrill recommended.
As explained earlier, the biggest downside to taking lender credits is that your interest rate will go up.
That won’t hurt too much in the short term, as your monthly payment may not appear to be much higher with the new rate. But if you keep your loan as is and don’t refinance within a few years, you will pay significantly more in interest over the life of the loan.
The other X-factor to consider is that every lender has a different pricing structure. That means one lender may be less or more expensive overall than another lender when it comes to lender credits.
That’s why it pays to request quotes from at least three different lenders. Each one will provide you with a loan estimate, and you can ask what they offer in terms of lender credits or discount points to make the loan more affordable.
Tips for negotiating a lender credit
Merrill explained that almost anything related to loans is negotiable, and lender credits are no exception.
“It’s important to note, however, that while lender credits are negotiable, you will need to substantiate any negotiation requests with empirical evidence,” he said.
That means coming to the negotiation table with as strong a position as possible. A high credit score, significant savings, and low debts can make you an exceptional borrower — one that lenders know will qualify for a loan with their competitors. If you’ve gotten quotes from several lenders, you can leverage them against one another to see who will give you the best deal.
“Outside of your credit score, your greatest leverage is the threat of doing business with another lender. Suggest that perhaps other lenders are willing to listen to what you have to say.”Than Merrill
What is a lender credit: FAQs
Lender credits do not have to be paid back in a direct sense. But you pay for the credits in the form of a higher interest rate, which increases the overall cost of your home purchase loan.
Yes, lender credits can be negotiable, depending on the lender. If your lender offers to provide a credit in exchange for an interest rate that’s higher than you desire, you can try to negotiate that rate down or perhaps take a smaller credit amount. You may be able to pay part of your closing costs upfront, while the lender pays some in exchange for a more modest increase in your mortgage rate.
Per the Consumer Financial Protection Bureau, lender credits appear on your closing disclosure documents. The closing disclosure includes all of the details of your loan agreement, including any amount the lender is paying at closing and the interest rate you will owe on the loan.
If you are unclear about the terms or don’t understand the lender credit agreement, be sure to ask your lender about them before you close and commit to the terms of the loan.
Lender credits provide flexibility to homebuyers because they allow you to make a home purchase with fewer out-of-pocket expenses (they can also be used when refinancing your home). But the caveat is that your interest rate will tick up slightly. That can make a big difference in the total interest you pay over the life of your loan, depending on how long you plan to keep the mortgage loan.
“Keep in mind that not all lenders provide lender credits,” Merrill said. “But they are a great source of revenue for banks, so it’s fair to assume that most will be willing to work out some sort of arrangement.”