Mortgage 101

What Is a Lender Credit and How Does It Work?

Published on: May 13, 2022

what is a lender credit

Homebuyers shopping for a mortgage frequently ask what is a lender credit. When you take a lender credit, the mortgage company agrees to pay some or all of your closing costs. In return, you agree to pay a higher interest rate.

You may want to consider a lender credit if you don’t have enough money saved to cover all of your closing costs. In this article, we’ll explore how lender credits work and look at situations where they might save you money.

What is a lender credit on a mortgage?

When you apply for a mortgage or refinance loan, you have the option of accepting a mortgage lender credit to lower your closing costs in exchange for paying a higher interest rate on your loan. The higher the rate you’re willing to pay, the more credits the lender will give you. Sometimes, the lender will add the charges to your loan amount rather than increasing your interest rate.

The lender will apply the credits to closing costs, including lender fees and third-party services required to close the mortgage, such as the appraisal and title search. Closing costs typically amount to 3% to 6% of the total loan, so they add up. For example, closing costs on a $300,000 mortgage could be $9,000 to $18,000.

While you can use lender credits for closing costs, you cannot use them as part of your down payment. They also can’t be used to meet any reserve requirement needed to qualify for a mortgage.

When considering mortgage lender credits, you have to weigh the tradeoff between higher monthly payments for the life of the loan and lower closing costs now. For instance, reducing closing costs may allow you to make a larger down payment and eliminate private mortgage insurance, resulting in bigger savings.

Lender credits vs. discount points

When thinking about the meaning of lender credits, it’s easy to confuse lender credit and discount points. Lender credits allow you to pay less upfront in exchange for a higher interest rate. With discount points, you pay more upfront in exchange for a lower interest rate.

Essentially, discount points are the reverse of lender credits. You pay extra interest upfront when you pay discount points to get a lower interest rate on your mortgage. A discount point, also called a mortgage point, is 1% of the loan amount. So, one point on a $250,000 mortgage is $2,500. Different lenders have different pricing structures, so how one mortgage point affects your interest rate depends on the lender and even on the mortgage market at the time.

How do lender credits work?

With discount points, you prepay interest for a lower long-term interest rate. But how do lender credits work? With lender credits, the lender pays closing costs in exchange for receiving higher interest payments over the long term.

For instance, say you want $4,500 to help pay closing costs on a $300,000 loan. In this example, the lender might agree and increase the interest rate by 0.25%, from 4.50% to 4.75%. On a 30-year loan with 20% down, your monthly payment for principal and interest would go from $1,216 to $1,252. So, you’d save $4,500 upfront and pay $36 more a month.

You can use a mortgage calculator as a lender credit calculator to compare how different interest rates affect your monthly payment. To determine when you’d reach the breakeven point, you would divide the amount of the credit by the difference in monthly payments. In the example above, you’d reach the breakeven point at 125 months, when you’ve paid as much in extra interest as you received in credits. In other words, if you sell or refinance before 10 ½ years, you come out ahead.

Are lender credits worth it?

Consider your personal financial situation and the broader economic picture to decide whether a lender credit is a good idea. In some scenarios, getting a lender credit and paying a higher interest rate may be beneficial, such as when:

  • You plan to move before you reach the breakeven point. The extra interest you paid will be less than the credit you received, so you’d save money.
  • You need all your cash for the down payment. Making a bigger down payment can result in a better loan offer or help you avoid paying for mortgage insurance. In that case, lender credits may be worth the bump in interest.
  • Interest rates are trending upwards. When mortgage rates are rising, it may make sense to buy before they can go up more. If you wait to buy until you’ve saved enough money for closing costs, mortgage rates may rise higher than the rate you would have paid to receive lender credits, costing you even more in the long run.

On the other hand, if you’re buying your “forever home,” you may pay significantly more in interest over the loan period if you take lender credits.

Additionally, if the lender adds the amount of the credits to your principal rather than increasing the interest rate, it could affect a future refinance. You’ll have to refinance the higher principal, so you’ll still be paying interest on the closing costs from your first loan when you get your new mortgage.

How to get lender credits

As you shop for a mortgage, ask the loan officers you talk to how to get lender credits. They may offer you a few options, with various amounts of credits for different interest rates. Every lender sets their own rates, so it’s important to compare loans from multiple lenders based on the same offer, such as the interest rate for one point of credit.

The credit will be listed on the loan estimate (page 2, Section J) as a negative number. On page 3, the estimate shows the annual percentage rate (APR), which is based on interest rate and loan fees. The lower the APR, the less expensive the loan will be over the full term.

Alternatives to lender credit for closing costs

Lender credits for closing costs are one way to save money at the closing table, but you end up paying for them with higher monthly payments. There are other options to cover your closing costs. 

Specifically, you may consider the following alternatives:

  • Ask the seller to pay. You can ask the seller to pay some of the closing costs. Do this as part of the contract negotiations when you make an offer on the house. Sellers are more likely to pay closing costs and make other concessions in slow markets when they don’t have multiple offers on the house. 
  • Apply for assistance programs. Check with your state housing finance agency and local nonprofits about closing cost assistance. These programs may have income or home-price ceilings, or assistance may be limited to first-time buyers or veterans, but it’s worth investigating. 
  • Ask for a down payment gift. If someone is willing to provide funds for your down payment, you can apply more of your savings to the closing costs. The donor must meet specific qualifications and provide a gift letter verifying the money is a gift. 

Are you ready to buy a home? Talk to a local Finance of America Mortgage Advisor today to learn more about your mortgage options.

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