What Is A Lender Credit And How Does It Work?

Buying a home is an expensive endeavor. From coming up with a down payment to paying for a home inspection and moving costs, there are expenses everywhere you turn. Additional costs may feel stressful if you have used every penny you have to afford your dream home without a lender credit. You may also experience sticker shock when you review your closing contract with all your closing costs.

If you’re worried about paying for those extra expenses, there’s a solution to help ease this financial burden: lender credits. If you’re wondering what lender credits are and how lender credits work, we’ve got you covered.

What Is A Lender Credit?

Did you know your closing costs can tack on an additional 3% – 6% of the total purchase price of your home? If you decide to purchase a $200,000 home, you could be looking at paying upward of $12,000 in closing costs alone. If you haven’t set this money aside, some lenders offer lender credits to help offset the cost.

A lender credit is defined as an arrangement where the mortgage lender allows the borrower to reduce all or part of their total closing costs in return for a higher interest rate. Generally, lender credits are calculated as a percentage of the loan amount. The lender will charge a higher interest rate in exchange for funds to offset your closing costs. When you use lender credits, you may pay less upfront but more over the longevity of the loan. The more lender credits you receive, the higher your interest rate will be.

Your interest rate will depend on your lender, the type of loan you apply for, and the mortgage market condition at the time of your application. Every lender has a different fee and pricing structure. So, even if you receive lender credits from one lender and receive a higher interest rate, you may be able to get a lower interest rate with the same amount of lender credits at a different financial institution.

How Does A Lender Credit Work?

Using a lender credit gives you cash upfront to help offset your closing costs, at the expense of a higher interest rate for the life of your mortgage. There isn't a single right answer for whether you should use lender credits. Instead, it depends on your specific financial situation. Here is an example of how using a lender credit might impact a $300,000 mortgage loan.

Lender Credits Vs. Discount Points

Discount points are another option borrowers use to help offset the cost of buying a home. With lender credits, you'll pay less upfront closing costs in exchange for a higher interest rate. In contrast, with discount points, you'll pay additional money upfront in closing costs in exchange for a lower interest rate. This allows the borrower to save money over the term of the loan. If you can afford your closing costs but want to lower your overall interest rate, consider this option. Points are a good option for homeowners who think they will need their loan for a long time.

Lenders calculate discount points in relation to your total loan amount. Typically, each point equates to 1 % on the loan balance. For instance, one point on a $200,000 loan would be $2,000 or 1%, while two points would be $4,000 or 2% of the balance. If you choose to buy points, you’ll pay for them at closing.

You can determine if discount points are right for you by doing a little bit of math. Let’s say that buying two points upfront on a $200,000 loan saves you $40 per month on your payment. Two points would be $4,000. If you divide that cost by your monthly savings, you get the breakeven point in a certain number of months. In this case, it would take you 100 months – a little over 8 years to breakeven. After that point, you start making money over the life of the loan.

It’s important to know that points are sold in increments of 0.125% of your loan amount, so you don’t have to buy whole points to consider the option. Like lender credits, your points are determined by the lender, the type of loan and the current mortgage conditions. It is common for each point that you pay to lower your interest rate by 0.125% or 0.25%

Pros And Cons Of Lender Credits

Using lender credits comes with pros and cons. Here's a look at some reasons to use (or avoid) using lender credits.

Pros Of Lender Credits

• You’ll pay less money upfront.
• You may be able to avoid PMI with a sufficient down payment.
• You may be able to put more money toward a down payment.
• You can save money and avoid the extra interest payments if you’re selling the house in a few years after buying.

Cons Of Lender Credits

• You’ll receive a higher interest rate and higher monthly payment.
• You may pay more in interest over the duration of the loan than you saved upfront.
• You may have to compare loan estimates from multiple mortgage lenders to get the best terms.

When Should You Use A Lender Credit?

Lender credits come with some advantages. In certain situations, it may make sense to use lender credits toward your closing costs. For instance, if your down payment and other home buying costs have spread your finances too thin, you may consider lender credits to help ease the financial burden of your closing costs. Using lender credits in this situation can help you avoid financial stress and make your budget go further. For some, coming up with $5,000 may be more challenging than paying an extra $15 a month.

Additionally, if you don’t plan on staying in your home for the entire term of the loan or if you’re considering refinancing, the use of lender credits may make sense. The small increase to your interest rate may not affect you in the short term, and the upfront benefits of saving thousands of dollars in closing costs will likely more than outweigh the additional monthly payment.

The Bottom Line

Buying a home is a big commitment that comes with a lot of financial responsibility. So, before you venture out to purchase your dream home, you must understand how much it will cost. If you're looking to save money on your closing costs, using a lender credit is one option to consider. Using a lender credit can lower the amount of upfront closing costs that you have to pay at the expense of paying a higher interest rate.

Compare lenders and mortgage options to ensure you select the most suitable loan that fits within your budget. If you're interested, you can always learn more about who pays closing costs in the home buying process. This can help you as you look to reduce your closing costs as part of buying your next home.