Wednesday, March 14, 2012
Mortgage Q&A: "What is a lender credit?"
Back before the mortgage crisis reared its ugly head, it was quite common for loan officers and mortgage brokers to get paid twice for originating a single loan.
They could charge the borrower directly, via mortgage points, while also receiving compensation from the issuing mortgage lender, via yield spread premium.
Clearly this didn't sit well with regulators, so in light of this perceived injustice to borrowers, changes were made that essentially limited a loan originator to getting just one form of compensation.
Borrower or Lender Compensation?
Now loan originators must choose between borrower or lender compensation, with many opting for lender compensation as a means to keep a borrower's out-of-pocket costs low.
With lender paid compensation, a lender essentially provides a loan originator with "X" percent of the loan amount as commission.
So a mortgage broker may receive 2% of the loan amount from the lender for funding the loan. However, in doing so, they are sticking the borrower with a higher mortgage rate. This is the tradeoff.
In other words, a mortgage with lender-paid compensation will come with a higher-than-market interest rate, all other things being equal.
Quick example of a lender credit:
Loan type: 30-year fixed
Par rate: 3.5%
Offered rate: 4%
As you can see, in this scenario the borrower actually qualifies for a par mortgage rate of 3.5%. However, they are offered a rate of 4%, which allows the loan originator to get paid for handling the loan.
The loan originator's lender-paid compensation may have pushed the interest rate to 3.75%, but there are still closing costs to consider. They may bump the interest rate up to 4%, using a "lender credit," to cover those costs so the borrower can refinance for "free." This is known as a no closing cost loan.
In other words, the loan originator increases the interest rate twice. Once for their commission, and a second time to cover closing costs.
On the Good Faith Estimate, you should see a line detailing the lender credit that says, "this credit reduces your settlement charges." It's a shame it doesn't also say that it "increases
your rate." But what can you do.
The obvious benefit is avoiding out-of-pocket expenses, which is important if a borrower doesn't have a lot of extra cash on hand, or simply doesn't want to spend it on refinancing their mortgage.
It also makes sense if the interest rate is pretty similar to one where the borrower must pay both the closing costs and commission.
For instance, there may be a situation where the mortgage rate is 3.5% with the borrower paying all the closing costs and commission, as opposed to 3.75% with all fees paid and the borrower receiving a lender credit.
That's a relatively small difference in rate, and the upfront closing costs for taking on the slightly lower rate wouldn't be recouped for years.
In the case of borrower paid compensation, the borrower pays all closing costs as well as the loan originator's commission.
The benefit here is that the borrower can secure the lowest possible interest rate, but it means they must pay out-of-pocket to obtain it.
They can still offset some of the out-of-pocket expense with a lender credit, but that will come with a higher interest rate, so it's somewhat counter-intuitive. And the credit can't be used to cover loan originator compensation. But do the math to see if it'll save you some money over lender-paid compensation.
Which is the Better Deal?
Generally, if you plan to stay in the home (and with the mortgage) for a long period of time, it's okay to pay for a lower rate. You could save a ton in interest long-term.
But if you plan to move or refinance in a relatively short period of time, a loan with a lender credit may be the best deal.
You won't have to pay much (if anything) for taking out the loan, and you'll only be stuck with a slightly higher mortgage payment.
As always, be sure to compare both options to determine which is the best deal (yes, you need a calculator).
There will be cases when a loan with the lender credit is the better deal, and vice versa. So shop around! You should be able to find a competitive rate with a lender credit.