- When you buy a home, you have to pay closing costs to finalize the transaction. Closing costs can range between 2% to 5% of your home’s total purchase price. As a result, they can add thousands of dollars to the upfront cost of purchasing a home.
- A lender credit is a sum of money your mortgage lender gives you to pay your closing costs. In exchange for this closing cost assistance, your lender will increase your mortgage interest rate for the duration of your loan.
- Using a lender credit can help you buy a new home sooner than you would be able to otherwise. However, in the long term, the increased interest rate can make your mortgage loan a lot more expensive.
What is a Lender Credit?
Buying a home comes with many costs. After you find a home in your price range, you’ll have to make a down payment and pay a closing fee to finalize the sale. Closing costs include a variety of expenses, like appraisal fees, inspection fees, title insurance, transfer taxes, filing fees, legal fees, and more.
Altogether, these fees can cost between 2% to 5% of your home’s total purchase price. If you’ve chosen a home that’s at the high-end of your budget, a hefty closing fee can push it beyond what you can comfortably afford.
Fortunately, lender credits make the upfront cost of buying a home a little more manageable. So what are lender credits and how do they work? Below, we’ll break them down for you.
What Are Lender Credits?
A lender credit is a sum of money your mortgage lender gives you to help you pay for closing costs.
While a lender credit can make your new home purchase a little easier upfront, lenders don’t give you this financial help for free. As this is not a true seller concession, you’ll end up paying them back in the form of a higher interest rate.
You can think of lender credits as the opposite of discount points. With discount points, you pay your lender a sum of money upfront to reduce your mortgage’s interest rate.
The Impact of Lender Credits and Discount Points on Your Interest Rate
Here’s how lender credits and discount points impact your interest rate:
- Par pricing – If you don’t use lender credits or discount points, you’ll simply pay the standard interest rate on your mortgage. For example, your lender may charge a par interest rate of 3%.
- Above-par pricing – If you use a lender credit, your lender will cover some or all of your closing costs. They will also increase your mortgage interest rate to an “above-par” rate. There’s no set formula for determining exactly how much your interest rate will increase with a lender credit. As a result, it’s a good idea to compare options from multiple lenders.
- Below-par pricing – If you use discount points with your mortgage, your lender will reduce your interest rate to a “below-par” rate.
Lender Credit Limitations
It’s important to note that lender credits can only be used to pay for common closing costs. They cannot be used towards your:
- Down payment
- Minimum borrower contribution
- Pre-existing debt you need to pay down to qualify for a loan estimate or mortgage
As a result, you won’t be allowed to pocket any extra money you receive from your lender credit that exceeds your closing cost amount.
For this reason, you should make sure you ask for a lender credit for the right amount. Otherwise, you could cause your interest rate and monthly payment to increase unnecessarily.
Lender Credit Example
Now that you understand the rules for lender credits, let’s take a look at an example of how they work:
- You want to buy a home that costs $200,000.
- You decide to make a 6% down payment, which costs $12,000. You have $18,000 saved up, so you can afford this down payment with ease.
- You discover that your closing costs will be $8,000 in total. This means that you’ll need to pay a total of $20,000 upfront to buy this home. With this extra expense, your chosen home starts to look out of your price range.
- Your lender offers you a lender credit. They agree to pay the $8,000 of closing costs on your behalf. In exchange for this lender credit, your lender increases your mortgage interest rate from 3% to 3.5%. Your monthly mortgage payment is slightly higher now, due to this increased interest expense.
As you can see, lender credits can make the initial process of buying a home a lot easier. However, they come with some downsides in the long run for the borrower.
The Pros and Cons of Using Lender Credits
The value of using a lender credit depends on your financial situation and the amount of time you plan to live in your new home.
In the short term, lender credits offer the following benefits:
- The ability to buy a home sooner – Lender credits prevent expensive closing costs from standing in your way of buying a new home.
- Breathing room in your budget – If your savings are limited, a lender credit can help you keep enough cash on hand to pay for home repairs, renovations, or a larger down payment.
- A negligible impact from the increased interest rate – Your increased interest rate will make your monthly mortgage payment a little higher. However, the extra money you pay in interest may still be less than your closing costs.
- Tax benefits – With a higher interest rate, you can deduct more money from your taxes.
As long as you refinance your mortgage or move out of your home before the increased interest expense exceeds your lender credit amount, the benefits of using a lender credit can outweigh the downsides.
What is the Lender Credit Break-Even Point?
At some point during your mortgage, the increased cost of your interest will “break-even” with the closing cost assistance you received from your lender credit. Once it does, your lender credit may have some downsides.
You can calculate your break-even point by dividing your total lender credit amount by your increased monthly interest expense.
The resulting number will tell you how many months you can stay in your home with the same mortgage rate before your lender credit costs more than it provided in closing cost assistance.
The main downside of using a lender credit is that it will increase your interest rate for the entire duration of your mortgage. If you choose to stay in your home for a long time, it can make your home loan more expensive than it would have been otherwise.
However, if you refinance your mortgage or sell your home before the break-even point, you can easily avoid this problem.
When Should You Use a Lender Credit?
As you can see, the value of lender credits depends on how much money you have saved when you decide to buy a home and how long you plan to stay in that home with the same mortgage rate.
Lender credits make sense if you don’t have enough cash to cover your closing costs comfortably. They come with very few downsides if you only stay in the home for a short amount of time.
In contrast, if you have ample savings to cover your closing costs, a lender credit will make your mortgage more expensive unnecessarily, especially if you choose to stay in the home for years to come.
NerdWallet. Mortgage Closing Costs: How Much You’ll Pay.
Consumer Financial Protection Bureau. What are (discount) points and lender credits and how do they work?https://www.consumerfinance.gov/ask-cfpb/what-are-discount-points-and-lender-credits-and-how-do-they-work-en-136/