A home purchase is one of the most significant financial decisions most people will ever make. Unless you’re paying for a home entirely in cash, which isn’t typical, it’s sensible to meet with your lender to discuss ways to reduce costs. Two methods of reducing how much you pay for your home are lender credit and discount points. But what is lender credit, and what are discount points?
Lender credits and discount points can have benefits, but it’s important to understand the difference between the two. To help you make an informed decision and prepare for a healthy financial future, here’s an explanation of how points and lender credits work.
What Is Lender Credit and What Are Discount Points?
As a starting point, imagine two homebuyer scenarios.
Scenario 1: A young couple decides to purchase a home where they plan to raise their growing family. Their parents are helping with the down payment, and they have sufficient funds for closing. Both individuals work full-time and have promising careers. They’re comfortable, but they’re aware of the expense of raising a family over time, and they’re concerned about their financial future.
Scenario 2: A single parent with two children in college decides to purchase a small home near the city where her children plan to live and work. Her available cash is currently limited, but with her children soon on their own, her expenses will go down. In addition, she anticipates rental income from her current home, although she may decide to sell later.
In one scenario, discount points might be a good choice, while in the other, lender credit might be the better option. Which homebuyer should choose points, and which should choose lender credit? Or neither?
Keep in mind that you’re not required to accept discount points or lender credits when applying for a mortgage but choosing to do so could help you in the short term or over time.
- Discount points lower the interest rate of your loan by paying a certain amount upfront.
- Lender credits allow you to lower your upfront costs by getting closing cost credits in exchange for a higher interest rate on your loan.
Among other considerations, your future plans should weigh heavily in your decision to take advantage of discount points or lender credit. Do you anticipate living in your home for the life of the loan or most of it? Is selling possible or likely in a few years? Other possibilities include refinancing later or paying the mortgage off early, both of which can make discount points less impactful.
Choosing between credits and points isn’t complicated when you understand the differences and evaluate your plans or potential lifestyle changes in the future. There is no one-size-fits-all answer, but with careful evaluation, you’ll have the information you need to make a decision.
Understanding Lender Language
In the process of searching for your new home, no doubt you’ve come across unfamiliar real estate terms. Words like pre-qual, contingencies, seller concessions, backup offers, and many others require close attention. In the same way, people who work at banks, mortgage loan companies, and other lending institutions have their own terminology. And those terms can be used in various ways.
With that in mind, mortgage lenders may seem to use points, discounts, and credit inconsistently. While specific programs are referred to with these terms, a lender may also use them in other ways.
For example, a mortgage lender might use the term “points” when talking about both discount points and lender credits. That’s because a “point” can refer to a specific amount of money: one percent of the loan amount.
Likewise, lenders also use terms like credit to talk about some form of compensation or bonus they may offer you, but that credit might not be related specifically to lender credits. For instance, if there is an error during the loan process, they may offer a “credit” to help make up for it. A mortgage lender might also offer a credit or incentive if someone referred you or the lending institution has a promotional offer, but these generally don’t impact your interest rate in the long term.
If a mortgage lender mentions terms like credits or points, don’t hesitate to ask for clarification. You’ll want to be sure of the facts and be able to make a sound decision that sets you up for success in the long term.
What Are Discount Points and How Do They Work?
Discount points allow you to pay more upfront to receive a lower interest rate. That lower interest rate could decrease your monthly mortgage payment or reduce how many payments you need to make before your home is paid off. If you don’t plan on refinancing or paying your mortgage off early, buying points could be a good option.
If you’re interested in buying points, remember that one point is equal to one percent of the loan amount. It’s not one percent of the interest rate, although it’s sometimes confused.
Let’s return to the young couple buying their first home, where they plan to raise their family.
If they take out a $100,000 loan, one point would represent 1% of that amount, or $1,000. They can also buy partial points, so a half-point would be $500, and one-and-a-quarter points would be $1,250.
If they choose to purchase points, the dollar amount will be due at closing, which will raise their total closing costs. However, the points purchased will lower the interest rate on their loan, which means they will have lower monthly payments. How much the interest rate is lowered depends on the lender.
Before deciding, they will need to ask their lender for specifics on how buying points will impact their interest rate and monthly payments. The more points they purchase, the lower their rate will be.
Your loan amount might not be as simple to work with as an even $100,000. However, your lender will make calculations appropriate to your situation and provide a Loan Estimate within three business days of you completing a loan application. The Loan Estimate lists details such as the type of loan, the loan amount, discount points, insurance, projected monthly mortgage payments, and estimated closing costs. It’s a good idea to carefully review the Loan Estimate to ensure it fits your expectations.
Keep in mind that a Loan Estimate isn’t an approval or denial of your application, and it does not mean you can’t change the details. It’s intended only as information about the loan package you discussed with your real estate agent. You can also use it to compare other offers side by side.
If approved, and you accept, the specific information relating to discount points you may have purchased will be listed in a Closing Disclosure, which your lender will provide at least three business days before closing. This document provides the finalized details and terms of the loan including lender fees, your monthly payments, and all expenses due at closing.
The exact amount you’ll save per point depends on the type of loan, the current market, your lender, and other factors.
What Is Lender Credit and How Does It Work?
Although not completely accurate, it’s helpful to think of a lender credit as the opposite of points. When you buy discount points, your closing costs go up. However, if you accept lender credit, your closing costs go down. On the other hand, by agreeing to pay points at closing you can get a lower interest rate over the life of the loan, which means your monthly payments will be lower over the term of the loan.
The single parent mentioned earlier, who plans to buy a small house in the city where her two adult children live, might want to understand what lender is? This may be a good option for her, as she currently has limited cash, but no concerns about future income or expenses. In addition, she has uncertain plans and may decide to move to a warmer climate in five or ten years.
By selling the home she plans to purchase, she will pay off the mortgage early. That makes the higher interest rate and higher monthly payment that accompanies a lender credit less impactful over time.
Lender credits are calculated in much the same way as points, and your lender might even call them “negative points.”
Lender credits are listed in your Loan Estimate and Closing Disclosure, just as discount points are. The more credits you choose to take, the higher your interest rate will be. However, other factors such as current interest rates and type of loan can affect the actual number.
Should I Use Discount Points or Credits?
Points may seem the most appealing option for many homebuyers, as even a small increase in the interest rate can add up over a 15- or 30-year mortgage. However, the situation isn’t always so straightforward.
The decision process needs to consider how much the purchase of points lowers your interest rate and monthly payments. What’s more, if you intend to refinance later or pay off the mortgage early, then buying points may not be a wise decision.
On the other hand, opting for lender credit in exchange for higher interest rates may seem unappealing at first. However, the money you save immediately may benefit you more than higher monthly payments will stress your budget in the future.
If you add all expenses incurred during your homebuying experience, including home inspections, appraisal fees, attorney fees, pro-rated property taxes, and lender fees, among others, home buyers need a lot of cash readily available in addition to a down payment. Saving on closing costs can help pay for moving expenses, home improvement, furnishings, and other necessities.
Understanding the differences between discount points and lender credits will help you make the right decision. Evaluating the pros and cons of each according to your own situation is essential.
Pros and Cons of Discount Points
Discount points allow you to reduce your interest rate by paying a certain amount upfront. The cost of a point is equal to one percent of the loan balance, so a point is equal to $1,000 with a $100,000 loan, $2,000 with a $200,000 loan, and so on.
Pros
- Paying for several points upfront could mean saving much more over the life of the loan.
- Points may be worthwhile when they help you lock in a lower interest rate if mortgage rates are expected to climb.
- A lower interest rate can mean a lower monthly payment.
Cons
- The upfront cost may not prove worthwhile
- The cost might not be feasible, especially considering other costs associated with homebuying and moving.
- If you plan to refinance or pay off your mortgage early, you likely won’t see the savings you expected.
Pros and Cons of Lender Credits
Lender credits allow you to reduce upfront costs by accepting a higher interest rate
Pros
- Lender credit saves money upfront, which is helpful if your available cash is low, or you have other immediate expenses.
- Choosing to invest the savings into your home could help you build equity or make your home more livable from the start.
- If you plan to sell or refinance your mortgage in the coming years, the increased interest rate may not have a substantial effect on you and may justify the initial savings.
Cons
- A higher interest rate could add up to tens of thousands of dollars over the life of your loan, especially if you’ve chosen a 30-year term.
- If you don’t refinance or pay off your mortgage early, you’re almost guaranteed to pay more interest than the upfront savings you gained.
Comparing Your Options
Understanding what lender credit is and how discount credits work, it’s important to evaluate your options, given your specific loan type, term, and rate. If you’re considering points or credits, you should ask your lender to help you visualize a few scenarios.
- Request a side-by-side comparison of your loan as-is, with a chart showing the interest rate and total paid minus one point and another that’s plus one credit.
- Ask for the same comparison, this time with the number of points or credits you’re considering (make sure they’re equal).
- Evaluate the same comparison again, but this time using the length of time you expect to keep the loan, rather than the full loan term.
These comparisons will take some time, but it’s essential that you fully understand your options before moving forward. Remember, you can also choose to take neither points nor credits and accept your loan as-is, which may be the best choice for you.
Reducing Your Interest Rate in Other Ways
When you’re almost ready to finalize your loan, buying points is a chance to lower your interest rate. However, If you’re only considering purchasing a home, and you want to be certain you get the best possible rate, it’s important to consider the following.
- Your debt-to-income (DTI) ratio is directly representative of the risk the lender is taking when approving you for a mortgage. Paying down debt is the fastest way to improve your credit score and reduce the risk the lender perceives, thereby lowering your interest rate.
- Your credit score is a major factor in the interest rate you’ll qualify for. You can raise your credit score by requesting negative items you don’t recognize (i.e., late payments) to be removed from your report, paying your credit cards on time, reducing balances, avoiding new inquiries, and avoiding new account openings or closures in the year leading up to your mortgage application.
- Your chosen loan amount will also impact your interest rate and monthly payment, as well as your “front-end DTI.” This reflects the percentage of your income required for housing costs. Choosing a loan for a lesser amount by choosing a more affordable home or making a larger down payment can reduce the lender’s risk and, therefore, reduce your rate.
- Your down payment amount generally must be a minimum percent of the home’s sale price, which helps the lender reduce their risk because you’re staking your own cash. It also reduces the loan balance.
Get Informed and Take the Next Steps
With this information in your arsenal, you’ll no longer wonder what lender credit is. Knowledge is power, especially when it comes to saving money on your home purchase. Now you’re equipped to confidently decide which avenue is best for your financial future.
Source: capitalbankmd.com ~ Image: Canva Pro