You’ve found your dream house and have just enough money to put down on it. After you apply for the mortgage, though, you find out you have closing costs that go beyond the money you have saved. Do you lose your dream house now?
Luckily, there is an answer. It’s called the lender credit. It’s the lender’s way of helping you pay the closing costs. Is there a catch? Kind of, but it’s not a big deal.
We’ll discuss how the process works below.
What is a Lender Credit?
First, let’s look at the lender credit. It’s a credit the lender gives you as a line item on your Settlement Statement. Let’s say your closing costs, including all lender and 3rd party charges total $5,000. The lender may issue you a $5,000 credit. This lowers your bottom line and what you must bring to the closing.
What’s the Catch?
Of course, there’s a catch. Lenders are in business to make money. They aren’t just going to give the mortgage away. If you opt for a lender credit, they will increase your interest rate. The good news is that it usually isn’t by very much. On average, lenders increase your rate 0.25%. Of course, this varies by lender. You may find some that increase it as much as 0.5%.
But, let’s look at how much of a difference this makes in your payment. Let’s say you need a $200,000 loan. A 4% rate would give you a $955 principal and interest payment. If you opted for the lender credit and took a 4.5% rate, your principal and interest would equal $1,013. That’s a difference of $58 per month. This means $696 per year. It would take 7 years before you would pay $5,000.
Does it Make Sense?
No, we need to determine if it makes sense to take the lender credit and pay the higher rate. In our above example, it would take 7 years before you started paying more than the $5,000. If you know you’ll move before 7 years passes, you’ll benefit from the lender credit. You don’t pay the closing costs and you’ll get away paying less in the long run because you’ll move.
Even if you won’t move, you might refinance. If you do so within 7 years, you’ll make out on the deal. You won’t pay as much as $5,000. Of course, if you refinance, you are looking at paying closing costs on the new loan, so you’ll have a new decision to make.
What happens if you plan to stay in the home for the next 30 years, though? At that point, the higher interest rate may not make sense. But, you have to look at the big picture. Just how much will a 4% rate cost you in interest over the life of the loan?
Over 30 years, you would pay $143,739 in interest. On the 4.5% rate, you would pay $164,813 in interest. Over the life of the loan, you would pay $21,074 more in interest with the higher rate. This goes to show that if this is your long-term home, you may want to come up with the money for the closing costs.
Paying for Closing Costs Without a Lender credit
What if you don’t have the money for the closing costs? Are you stuck paying the thousands of dollars in interest for the next 30 years? The good news is that you have options. Many loan programs including conventional, FHA, VA, and USDA allow you to accept gift money. This is money you receive from a relative, employer, or charitable organization.
The key word here, however, is gift. This money cannot be a loan. A friend cannot loan you the $5,000 for the closing costs and expect repayment in 2 years, for example. The lender will ask for proof that it is not a loan. This is usually done with a Gift Letter. This letter must state the reason for the gift (purchasing a home), the amount, the date, and that repayment is not expected.
The lender doesn’t stop there, though. They will also want to source the funds. In other words, they will track where the money originates. They’ll need to see proof that the donor took the funds out of their own account and that you deposited them in your account. The lender may ask for proof of where the donor got the funds if there is a large deposit in their bank account in the last few months. The lender just needs to confirm that the money truly is a gift and that a loan doesn’t exist somewhere.
If the money is a loan, the lender would have to include it in your debt ratio. This could ruin your chances of mortgage approval if you are close to the maximum.
Negotiating the Lender Credit
Of course, you don’t have to take the lender’s offer at face value. Let’s say they offer you a ‘no closing cost loan’ in exchange for a 0.5% higher rate. If that’s not acceptable to you, try negotiating. You can also shop around. This gives you more negotiating power. If you tell the lender you are shopping around, they may lower your rate just to keep your business. A lower rate is better than no business.
If a lender won’t lower your rate, see what other lenders have to offer. Don’t accept a rate you are not sure you can afford, especially if you don’t think you’ll refinance in the future.
A lender credit can be very helpful, but you must determine your total cost for the loan. Don’t assume because the lender pays your closing costs that it’s the best deal available. Sometimes paying the closing costs is the cheaper option in the long run. Once you determine the best choice for you, you’ll have a loan you can afford and lower your risk of default.