Understanding Lender Credits To Closing Costs

What Is a Lender Credit?

A “Lender Credit” towards closing costs is a cash credit a borrower receives at closing from the lender in exchange for a higher interest rate.  This is the opposite of paying “Discount Points”, where a borrower pays a fee to the lender at closing in exchange for a lower interest rate.  Sometimes a lender may offer a “Lender Credit” that is not connected to the interest rate you pay.   Examples may be a temporary offer, to compensate you for a problem, or most commonly as “restitution” for an error made on a disclosure during the loan process.

Lender Credits are often calculated as a percentage of the loan amount, and can appear on your Loan Estimate or Closing Disclosure as a “negative percentage” or “negative points”.  For Example:   Your Lender offers you a 3.5% interest rate on a $100,000 mortgage.  You have limited funds available for closing and would like to reduce the closing costs.  Your lender offers you an interest rate of 3.75% with a credit of “1 point”, or 1% of the loan amount, which equals $1,000.   In essence you are increasing your interest rate by .25% for a $1,000 credit to your closing costs.  You will pay a slightly higher monthly payment, but will reduce the amount of money you need to bring to closing by $1,000.

What Is a No Closing Cost Loan?

A “No Closing Cost Loan” is a type of Lender Credit where your lender pays all your closing costs in exchange for a higher interest rate.  This is common in certain type of refinances like FHA Streamline Refinances and VA IRRRLs where the borrower does not want to come to closing with any money & would also like to keep the new loan balance from increasing as a result of refinancing.  

What are Discount Points?

Paying “Points” or “Discount Points” to a lender is a fee that a borrower pays at closing in exchange for a lower interest rate. This is the opposite of receiving a Lender Credit.  “Points” is a term that the mortgage industry has used for many years. Some lenders may use it to refer to any upfront fee calculated as a percentage of your loan amount, regardless of whether you receive a lower interest rate or not.  

The information below discusses “Points” and “Lender Credits” that are negotiated between you and your lender in exchange for a lower interest rate.  Whether or not negotiating a lower interest rate or a higher one in exchange for a closing cost credit makes sense for you depends on your unique situation.  Foundation Mortgage’s mortgage bankers are here for you to help explain the ins and outs of each option to help you arrive at the option that suits your needs and situation.  

What are Benefits & Risks of Paying Discount Points or Receiving a Lender Credit to Closing Costs?

Deciding whether you should negotiate a lower interest rate, or take a higher one in exchange for a closing cost credit with your lender can be confusing.  So, what information do you need to decide which, if either option is best for your scenario? For starters you need to understand how each option can benefit, or hurt you, both initially and over the life of the loan. The questions you should ask your mortgage banker when comparing 2 options against one another include:

  1. What will my interest rate be without any points or lender credits?

  2. What will the difference in my monthly payment be?

    • If you pay points in exchange for a lower rate your monthly payment will go down.  

    • If you receive a lender credit in exchange for a higher interest rate your monthly payment will go up.

    • Determining the decrease or increase in your monthly payment is the first step to determining whether one of these options makes sense for you.

  1. What is the upfront fee for the lower rate Or lender credit for the higher rate?

    • After you have determined the impact on your monthly payment, you will want to determine what fee you will pay or credit you will receive at closing from your lender.

    • Once you know the impact on your monthly payment & the cost/credit at closing, you can determine the “break-even point”.

  1. What is your “Break-Even Point”?

    • The “Break Even Point” is the point in time where your upfront fee/lender credit meets the savings/cost in your monthly payment.

    • Discount Points Paid In Exchange for a Lower Interest Rate

      • There is a point in time where the fee you paid at closing is recovered through the lower monthly payments your lower interest rate rewards you with.

      • The “break-even” is the number of months it takes for you to recoup the cost of the upfront fee.

      • This is important because once you know the “break-even point” you can determine how long you will need to keep the loan before paying it off or selling the property in order to recover the up-front fee paid.

      • From this point you can also determine the amount of interest you will save over the life of the loan if you never pay the loan off or sell the property.

    • Lender Credit Received in Exchange for a Higher Interest Rate

      • There is a point in time where the savings you received as a result of your lender credit is completely eroded by the higher monthly payments your increased interest rate costs you.

      • The “break-even point” is the number of months it takes for your lender credit to be offset by the higher monthly mortgage payment.

      • This is important because once you know the “break-even point” you can determine how long it will be before the higher interest rate starts costing you money.

      • Depending on how long you plan on carrying the loan or when you plan on selling the property will help determine whether negotiating a higher rate in exchange for a lender credit makes sense for your situation.

  1. How does paying “Points” or Receiving a “Lender Credit” impact your cash-to-close & loan approval?

    • Paying “Points” or receiving a “Lender Credit” can impact your loan approval in two ways.

    • Your “Debt Ratio”

      • Your Debt Ratio is a percentage of your total monthly debt vs. total monthly income.   Your “Debt Ratio” is one of the primary factors lenders use in qualifying you for a loan.  

      • Paying “Points” in exchange for a lower interest rate has the effect of lowering your monthly payment which in turn lowers your “Debt Ratio”.  A lower “Debt Ratio” can improve the likelihood your loan is approved if your overall debt load is high.

      • Receiving a “Lender Credit” in exchange for a higher interest rate has the effect of increasing your monthly payment which in turn increases your “Debt Ratio”.  A higher “Debt Ratio” could negatively impact your ability to qualify for a loan if your overall debt load is high.

    • Cash-To-Close and Reserve Requirements

      • Lenders also review whether you have sufficient cash-to-close as part of the Underwriting process.  Some loan programs also require you to have a certain amount of post-closing reserves.

      • Paying “Points” in exchange for a lower interest rate increases your cash-to-close & can negatively impact your loan approval if you have limited cash-to-close and/or no reserves.

      • Receiving a “Lender Credit” in exchange for a higher interest rate can help you with your loan approval if you have limited or are short cash-to-close by reducing the total amount of needed for closing.

The chart below is an example of the tradeoffs you make with “Points” & “Lender Credits”. In this example, you take a loan amount of $180,000 with a 30 year fixed mortgage with a 5% interest rate with no points/lender credit.  The first column shows a loan option where you pay “Points” to reduce your interest rate.   The second column shows the no points/lender credit option.  And the third column shows a loan option with a “Lender Credit”.

RATE

4.875%

5%

5.125%

POINTS

+.375

0

-.375

SITUATION

You plan to keep you mortgage a long time.  You can afford to pay more at closing.

You are satisfied with the market rate and your closing costs with no points or lender credit.

You don’t want or can’t afford to pay a lot of cash up front & can afford a higher mortgage payment.

YOU CHOOSE TO

Pay points now to get a lower interest rate.  You will save money in the long run through lower monthly mortgage payments.

Zero Points.

Pay a higher interest rate/monthly payment now to reduce or eliminate all of your closing costs.

WHAT IT MEANS

You will pay $675 more in closing costs now to save $14 a month on your mortgage payment

With no adjustment in either direction it’s easy to understand what your paying and what the costs are.

You will pay $675 less in closing costs now but your monthly mortgage payment will  increase by $14 a month.

BREAK EVEN POINT

It will take 48 months or 4 years to recover the money paid upfront for your lower rate.

It will take 4 years before the savings received from your lender credit is eroded and lost through higher monthly payments.

LIFE OF LOAN SAVINGS

You will save $4,368 over the remaining 26 years of the loan buy buying the lower interest rate.

None.

If you never pay the loan off it will cost you $4,368 over the life of the loan because of the higher monthly mortgage payments.

As seen in this example the option that makes the most sense ultimately depends on your plans for the loan and the property.  If you plan on remaining in the property for a long time and will not pay down or pay off the mortgage, it may make sense for you to pay “Points” in exchange for a lower interest rate.   If you are unsure of your plans, it is probably best to do nothing and just keep it simple and take the market interest rate.  

If you plan on selling the property, paying off the loan in a short time (less than 4 years), or have limited funds for closing and want to maintain some post-closing liquidity then it may make sense to pay a higher interest rate in exchange for a lender credit and lower closing costs.  Determining the “break-even point” and your plans for the property and loan repayment will put you in position to decide whether negotiating a lower interest rate or lender credit will make sense for you.

Does a No-Closing Cost Loan Make Sense For Me?

As mentioned above, a “No-Closing Cost” loan is an extreme example of a lender credit.  This type of loan is common with certain types of refinance transactions.  In a “No-Closing-Cost” loan, the lender pays all of your closing costs for you in exchange for a higher interest rate.  Because all of your closing costs are paid by the lender, there is no cost associated with the financing and as a result, there is no “break-even point”.  Any improvement in interest rate results in a benefit to the borrower.  This sounds great, but you should still go through the process above to determine whether a “No-Closing Cost” makes sense for you.  

Generally speaking, if you plan on holding the property for a long time and have no plan to pay down or payoff the mortgage then “No-Closing Cost” loans are a bad option.  Over time, the higher interest rate paid to get your “No-Closing Cost” loan will cost thousands if not tens of thousands of dollars in higher mortgage payments.  On the other hand, if you plan on paying off the mortgage or selling the property in the relatively near future, a “No-Closing Cost” loan can be a great option for you.