You’re probably aware that you’ll need to pay closing costs when you buy a home. But did you know that you can avoid paying closing costs? You can! The answer is lender credits, which let you roll your expenses into your loan. In exchange for not paying your closing costs upfront, your lender charges you a higher interest rate over the life of your loan.
Lender credits can be an appealing option for home shoppers on a budget. But are they worth the cost? We’ll take a closer look at the benefits and drawbacks of lender credits and help you decide whether taking lender credits is right for you.
What Is A Lender Credit?
Let’s go over closing costs before we fully dive into lender credits.
Closing costs are processing fees that you pay to your mortgage lender in exchange for finalizing your home loan. Closing costs pay for things like your appraisal and any pest inspections that your state requires before closing. The specific closing costs you’ll pay vary depending on where your home is and what type of loan you get. During the last stages of your loan, your lender covers the costs of these services. The lender then charges these services to you in the form of closing costs.
Closing costs can be more expensive than you might anticipate. Closing costs typically equal 3% – 6% of your total loan value when purchasing a home. That means if you buy a home with a $200,000 loan, you can expect to pay an additional $6,000 – $12,000 in closing costs. These costs come in addition to anything that you pay in a down payment.
If your lender offers you credits, it means they’ll absorb your closing costs and shoulder the costs themselves. In exchange, you agree to take on a higher interest rate than you would get if you paid the closing costs yourself out of your own funds. The amount that your interest rate increases depends on how many credits you take. The more credits you accept, the more money your lender will “credit” you for your closing costs and the higher your new interest rate will be.
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Are Lender Credits Worth It?
Lender credits can be a huge advantage for homeowners who are short on cash. However, it’s important to remember that lender credits aren’t free money. You pay for anything you take out in credits over the course of your loan through a higher interest rate. Your payment may only increase by a few dollars each month and this small increase can add up to thousands of dollars in a short amount of time. Let’s look at an example.
Let’s say you want to buy a home with a $200,000 principal loan balance and a 30-year term at 4% Your lender tells you that when you close, you’ll need to pay $6,000 in closing costs. You can take on an interest rate of 4.25% if you don’t want to cover your own closing costs. The only thing you need to pay for is a down payment in exchange for accepting higher interest rates. You may not have this money on hand after you calculate your down payment, so you decide to take the lender credits.
Your monthly payment each month is $983.88 because you took the lender credits. By the time your loan matures and you totally own your home, you’ll have paid your lender $154,196.73 in interest.
Now, let’s take a look at what you’d pay if you covered your own closing costs. You’d pay $6,000 to your lender upfront at 4% – paying your own closing costs means a lower interest rate. In this example, your monthly payment would be $954.83. That’s just under $30 less per month than the higher APR. However, over the course of your loan, you pay a total of $143,738.99 in interest. Even after you subtract the $6,000 you paid in closing costs when you took your loan, this loan is over $4,500 less expensive. Even a small increase in your APR makes a big difference in how much you end up paying.
Let’s take a closer look at some more benefits and drawbacks of lender credits to help you decide if they’re right for you.
Lender credits can offer some powerful benefits, especially if you’re short on cash:
- You’ll pay less money upfront to your lender. The major benefit of lender credits is that they allow you to close on your mortgage loan without paying thousands in closing costs. The average home buyer pays 3% – 6% of their loan’s value in closing costs, which can quickly add up to thousands of dollars. Credits can potentially mean the difference between closing now and more months of saving.
- You may be able to avoid PMI. If you’re getting a conventional loan, your lender will require you to pay private mortgage insurance if you don’t have at least 20% to put down on your home loan during closing. PMI is a type of protection that safeguards your lender if you stop making your loan payments.
You might not have the money to pay for your closing costs, but you also don’t have a 20% down payment. You might still want to take the credits. You can then apply the money you would have paid in closing costs toward your down payment. This can be more financially beneficial for you for two reasons: The higher your down payment, the lower your potential interest rate. Additionally, the premiums for PMI are bucketed based on the size of your down payment. If you can make a slightly higher down payment to get into a lower bucket, you may not have to pay as much for PMI. Do the math with your lender’s offered rates and see if you can save using credits.
- Your monthly payment will only slightly increase. Depending on how many credits you take, your monthly payment may only rise by a few dollars. If you’re like most home buyers, paying an extra $30 a month toward your mortgage is much more feasible than coming up with $6,000 or more to close.
- You might not feel the sting at all. The main drawback of a higher interest rate is that you pay more for your loan as it matures. Let’s say you plan to sell your home or refinance in a few years. You might end up paying just a few hundred dollars more in interest. When you compare this amount to the thousands you may pay during closing, you end up saving money using credits.
Things To Consider
Here are a few things to consider before you accept those credits.
- Credits mean you could pay thousands more for your loan. Using credits can save you money if you’re only planning on living in your home for a few years. However, you’ll end up paying more over the life of your loan. Even a small percentage increase can mean spending thousands more on a home loan. This is especially true if you take on a 30-year mortgage. The longer you plan on living in your home, the more you’ll pay in interest.
- Refinancing can cost you more money. Planning to refinance your loan in a few years when interest rates drop? Remember that refinancing also requires you to pay closing costs. As a general rule, you can expect to pay 2% – 4% of the total value of your loan. If you’re taking credits because you plan to refinance in the future, you still need to make sure you have the cash to pay up later on.
- There are other ways to save on closing costs. There are more affordable ways to cover your closing costs than taking on a permanently higher interest rate. For example, you can ask the seller to pay a percentage of your closing costs. If the seller really wants to close the sale, they may be willing to pay a portion of your closing costs to seal the deal. Alternatively, if your seller doesn’t have the cash on hand, you may be able to convince them to accept a lower final selling price. You can then divert that money toward your closing costs. These creative solutions save you money on interest and lessen the burden of closing costs.
Lender credits help you spend less on closing costs. When you accept lender credits, your lender agrees to cover all or some of your closing costs. Closing costs can equal thousands of dollars, so this is a major benefit. However, you’ll pay a higher interest rate in exchange for your savings.
Lender credits can save you money if you plan to live in your home for only a few years. Your monthly payment may only increase by a few dollars a month, which you might find more realistic to pay compared to thousands at closing.
However, if you live in your home for a longer period of time, this interest adds up. Consider asking your seller to cover a portion of the costs for you if you want to save on closing costs without accepting a higher interest rate.
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