Lender Credit: What You Need to Know
If you’re a homebuyer on a tight budget, a lender credit can help reduce how much you need to pay in closing costs. But there’s a catch: The credit usually comes with a higher interest rate.
A mortgage lender credit may be worth it if you’re short on cash, but you’ll want to consider the drawbacks, too.
What is a lender credit?
A lender credit is a cash credit you receive from your lender to cover some or all of your closing costs. Lender credits reduce the amount of upfront cash you need to buy or refinance a home, and are usually associated with no-closing-cost mortgages.
But despite that association, lender credits don’t cause closing costs to vanish. Instead, your lender will pay them, then charge you a higher interest rate for the life of your home loan. That, in turn, will up your monthly mortgage payment — so you could also end up paying thousands of dollars more over the life of the loan due to that increased interest rate.
However, that doesn’t mean that lender credits are always a bad idea. Closing costs will usually run you between 2% and 6% of the loan amount, which on a $470,000 home comes to between $9,400 and $28,200. It can be far easier to afford an extra $60 per month on your mortgage payments than to come up with an extra $6,000 in order to close on the house.
Lender credit limitations
A lender credit can’t be used for the following:
- A down payment
- The cash reserves needed to prove you have the means to pay your mortgage if you lose your income
- The funds needed to pay off debt in order to qualify for a mortgage
How lender credits work
While lender credits are tied to your interest rate, there’s no set formula for how to calculate the value lender credits give you — some lenders are simply more expensive than others and will offer you less value for a one-percent lender credit than their competitors. That’s why it’s crucial to comparison shop.
The example below shows how a lender credit might affect both your closing costs and monthly mortgage payments if you were to take out a $470,000 loan with a 20% down payment and an estimated $9,400 in closing costs. We’ll assume that for every quarter of a percentage point higher in interest rate, your lender will apply 1% of your loan amount toward closing costs.
| Lender credit amount | Interest rate | Closing costs remaining after lender credit is applied | Monthly payment amount (principal and interest) | |
|---|---|---|---|---|
| Loan A: No lender credit | none | 6.39% | $9,400 | $2,349.44 |
| Loan B: Small lender credit | ($4,700) | 6.64% | $4,700 | $2,411.30 |
| Loan C: Larger lender credit | ($9,400) | 6.89% | $0.00 | $2,473.82 |
Lender credits require you to weigh short-term financial perks against the long-term costs of a mortgage. Here’s what the example above shows:
| Short-term benefits for Loan B: | Long-term costs for Loan B: |
|---|---|
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| Short-term benefits for Loan C: | Long-term costs for Loan C: |
|---|---|
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Tip
Your lender credit will show up on page 2, section J of your loan estimate or closing disclosure. It will be listed as a negative number, since it’s reducing how much you need to pay at closing.
Pros and cons of lender credits
| Pros | Cons |
|---|---|
More cash in your pocket at closing time Potential to free up money for a larger down payment, which in turn could help you avoid private mortgage insurance Reduces the time it takes to recoup your costs Could allow you to purchase a home sooner Potential to claim the mortgage interest deduction on your taxes because your rate is now higher | May lead to a higher interest rate and monthly payment for the life of the loan More interest due over the life of your loan May make it harder to qualify, since it’s tougher to qualify for a mortgage that requires a higher monthly payment Could make the closing costs of a future refinance more expensive, since you’ll have a higher loan balance than you would have if you hadn’t used a lender credit |
How to negotiate a lender credit
Lender credits vary from lender to lender. Further, the loan program you choose, as well as mortgage market conditions, can also affect lender credit rates. Because there’s no specific formula for tying interest rates to lender credits, you should compare rates from three to five lenders to see which offers the most in credit for the lowest rate.
Lender credits vs. discount points
Think of a lender credit as the opposite of paying mortgage points in order to get a lower interest rate. With points, you pay an upfront fee to reduce your rate, but with lender credits a lender fronts your closing costs in exchange for a rate bump.
→ Lender credits make sense if: You’re planning on staying in this home just a few years or you’re trying to maximize the equity you hope to tap with a cash-out refinance.
→ Mortgage points make sense if: You’re planning to stay in your home for the long haul and have the funds to cover the higher monthly payments and increased interest costs.
Are lender credits worth it?
Lender credits are worth considering if you don’t have the cash to pay closing costs for a home purchase or refinance. If you’re doing a cash-out refinance, lender credits can also help you pocket extra cash to pay off high-interest-rate credit cards or finish a home improvement project.
A lender credit also might make sense for:
- First-time homebuyers who want emergency cash on hand. Many financial planners recommend having a rainy-day fund to cover three to six months of living expenses.
- Setting up a repair and maintenance fund. Insurance experts suggest setting aside at least 1% of your home’s value to cover maintenance costs or to pay for a major repair like a roof leak or replacing an air conditioning system.
- Covering the costs of FHA streamline refinancing. If you already have an FHA loan, an FHA streamline loan can help you refinance with less paperwork. However, this type of loan doesn’t allow you to roll closing costs into the loan amount. If closing costs are a concern, ask to see if your lender also offers a no-cost FHA streamline option to cover the costs in exchange for a higher interest rate.
FHA Mortgage Insurance Reductions in 2023
FHA mortgage insurance is getting cheaper in 2023. As of March 20, the Federal Housing Administration (FHA) reduced its annual insurance premiums by 0.30 percentage points. That’s good news for the average FHA borrower, who will save around $800 per year as a result.
- Paying off high-interest revolving debt. If you’re coming up short on funds to pay off maxed-out credit cards with a cash-out refinance, a lender credit might help you pay off the revolving debt more quickly.
Cash-out Refinance Rate Changes for 2023
Beginning May 1, 2023, conventional cash-out refinances are getting more expensive. Expect to see higher interest rates or an extra fee at closing if you’re taking cash out and borrowing more than 30% of your home’s value. The fee will range from 0.375% to 5.125% of your loan amount, depending on your credit score and LTV.
- Keeping money on hand to meet a lender reserve requirement. Some loans require borrowers to have mortgage reserves — extra cash on hand to make several monthly mortgage payments in the event of an emergency. Extra funds in a bank account lessen the chances of a mortgage denial.
Example of how lender credits affect your break-even point
Lender credits offer one more important benefit: They can help shorten the break-even point (the time it takes to recoup your mortgage costs) on a purchase or refinance. This is especially important if you’re refinancing a home you intend to sell within the next few years.
The table below compares the break-even points for two different refinance loans, one with a lender credit and one without. For the purposes of our example, the original loan has an interest rate of 6.25% and an existing loan balance of $350,000. Your current monthly payments on this loan are $2,155.01.
| Refinance Loan A | Refinance Loan B | |
|---|---|---|
| Lender credit amount | $0.00 | '-$7,000 |
| Out-of-pocket 2% closing costs | $7,000 | $0.00 |
| Interest rate | 5.25% | 5.75% |
| Change in monthly payment amount | '-$222.30 | '-$112.51 |
| Break-even point | 31 months | Immediately |
With Loan A, the break-even point is 31 months, so this loan option wouldn’t make sense if you plan to sell your home within two years (24 months). Loan B, although it is the higher-interest loan, lets you save $112.51 per month, for a yearly savings of $1,350.12 that starts immediately.
Lender credit alternatives: Other ways to reduce closing costs
A lender credit is just one way to slash closing costs. It might pay to also consider these options:
- Apply for closing cost assistance. Some state and local housing agencies offer down payment assistance (DPA) programs that also help with closing costs if you meet certain income and neighborhood requirements.
- Ask the seller to pay your closing costs. Most home loans allow sellers to pay closing costs on behalf of borrowers (this is called a “seller concession”). For example, with an FHA loan, a seller can pay up to 6% of your FHA closing costs.
- Ask a relative for a gift to cover closing costs. If you have a family member or friend willing to help, many loan programs allow a donor gift to cover closing costs.