Understanding Lender Credits

What are lender credits?

Very basically, it’s a trade-off between you and the lender where you agree to pay a higher interest rate in return for less or no closing costs. You are expected to pay closing costs to finalize your loan application. It encompasses legal fees, underwriting fees, filing fees, and sometimes home appraisal and inspection costs.

On average, closing costs equal about 2%-5% of your chosen loan amount. For a $400,000 mortgage loan, for example, that’s an additional cost of $8,000 to $20,000. If you haven’t budgeted enough cash for closing costs, lender credits can help you take out that loan anyway. But be aware that the more lender credits your accept (i.e. the less you choose to pay in closing costs), the higher your new interest rate will be.

A slightly higher interest rate will matter more depending on your financial goals. If you are choosing a long-term loan (30 years), a higher interest rate won’t increase your monthly payments by much, but it will make your total loan repayment amount much greater. However, if you choose a short-term loan, even a slightly higher interest rate could significantly increase your monthly payments, but the total loan repayment amount would be about the same. Aside from loan term length, whether you get a fixed-rate or adjustable-rate mortgage loan also shapes the impact you’ll receive from lender credits.

Are lender credits worth it?

If you only keep your loan for a few years (5 years or less), then a slightly higher interest rate won’t make much difference. Even if you take out a 30-year-term loan, you can choose to refinance after 5 years and avoid paying the larger interest amount altogether. Just keep in mind that refinancing also comes with closing costs.

Other benefits of lender credits:

• You can buy your home now as opposed to months or years later, after you’ve saved enough cash for closing costs. If you’re looking to buy a home in a hot real estate market where prices and interest rates will be rising, the small rate increase due to lender credits could still land you with a lower interest rate compared to the one you’d get if you waited another year or two.  

• You can avoid PMI. Private mortgage insurance is generally required if your down payment is less than 20% of the loan. You can use the money you would have spent on closing costs to increase your down payment instead, and avoid the added monthly cost of PMI.

• You can refinance for cheaper. If you live in an area with falling interest rates, it makes sense to refinance at the current low rates. But if you wait a few months in order to save up for closing costs, the interest rates could rise again and you’d have lost the opportunity. Lender credits would help you take advantage of the current market. And the slightly higher interest rate will likely still be significantly lower than your previous rate.

Despite the many benefits, lender credits aren’t always the right choice for everyone. Keeping monthly payments low, for example, may matter more than the overall repayment amount. Low (predictable) monthly payments could allow you to save more each month, improve your credit score, and lower your debt-to-income ratio--all of which would improve your loan options the next time your refinance or take out a mortgage loan.

Like with every other facet of mortgage loans, comparing multiple offers is key. And since lenders each structure their loans and lender credits differently, be sure to compare them on equal footing. Some, for instance, will only cover origination fees while others might offer a no-closing-cost mortgage. Choose what makes the most sense for your situation and loan type.

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