The Opposite of Paying Points on Your Mortgage

Mortgage Q&A: “What is a lender credit?”

If you’ve been shopping mortgage rates, whether for a new home purchase or a refinance, you’ve likely come across the term “lender credit.”

These optional credits can be used to offset your closing costs. But they will bump up your interest rate in the process.

Let’s learn more about how they work and if it makes sense to take advantage of them.

Jump to lender credit topics:

– How a Lender Credit Works
– What Can a Lender Credit Be Used For?
– Lender Credit Limitations
– Borrower-Paid vs. Lender-Paid Compensation?
– Lender Credit Example
– A Lender Credit Will Raise Your Mortgage Rate
– Does a Lender Credit Need to Be Paid Back?
– How to See If You’re Getting a Lender Credit
– Is a Lender Credit a Good Deal?
– Lender Credit Pros and Cons

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. This reduces your burden and makes their offer appear a lot more attractive.

However, when you select a mortgage that offers a credit, your interest rate will be higher to absorb those obligatory costs.

Simply put, you pay less money upfront to get your loan, but more over time via a higher rate/payment.

But remember, while you don’t have to pay these fees at closing, they are still paid by you. Just over time as opposed to at closing out-of-pocket.

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.

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.

This frees up the cash for the down payment that might otherwise go elsewhere.

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 choose an appropriate lender credit amount that doesn’t increase your interest rate unnecessarily.

If money is left over, it may be possible to use it to lower the outstanding loan balance via a principal curtailment.

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.

They could charge the borrower directly, via out-of-pocket mortgage points. And also receive compensation from the issuing mortgage lender via yield spread premium.

Clearly this didn’t sit well with financial regulators. So in light of this perceived injustice to borrowers, changes were made that limit a loan originator to just one form of compensation.

Nowadays, commissioned loan originators must choose either borrower or lender compensation (it cannot be split).

Many opt for lender compensation to keep a borrower’s out-of-pocket costs low.

Lender-Paid Compensation Will Also Increase Your Mortgage Rate

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 the borrower might not have to pay any settlement costs at closing, helpful if they happen to be cash poor.

This is the tradeoff of a lender credit. It’s not free money. In reality, it’s more of a save today, pay tomorrow situation.

Let’s pretend the loan amount is $500,000 and the par rate is 3.5% with $11,500 in closing costs.

You don’t want to pay all that money at closing, who does? Fortunately, you’re presented with two other options, including a rate of 3.75% and a rate of 4%.

The monthly principal and interest payment (and closing costs) look like the following based on the various interest rates presented:

• $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 loan 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 with the 3.75% rate who pays $4,000 in closing costs.

And roughly $142 more than the borrower who takes the 3.5% rate and pays $11,500 at closing.

So the longer you keep the loan, the more you pay with the higher rate. 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.

In the scenario above, the borrower 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. It also 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 this allows them to refinance for “free.” It’s known as a no closing cost loan.

In other words, the lender increases the interest rate twice.  Once to pay out a 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.

They’re simply structuring the loan where more is paid over time as opposed to at closing, which can be advantageous, especially for a cash-strapped borrower.

As noted, the clear benefit is to avoid out-of-pocket expenses. This 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 closing costs and commission. And 3.75% with all fees paid thanks to the 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.

The Larger the Loan Amount, the Larger the Credit

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 borrowers 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 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, there are options.

You can use seller contributions to cover their commission (since it’s your money) and a lender credit for other closing costs.

[Are mortgage rates negotiable?]

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 if you hold onto your mortgage for decades.

But if you plan to move/sell 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 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?