Lender Credits and Discount Points: How Do They Work?

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If you're comparing home loans, there's a good chance you'll come across discount points or lender credits in some of the paperwork. It can be helpful to know what they mean and why you might benefit from one or the other.

Here, we'll cover how discount points and lender credits work. Then, we'll explore some situations where it makes sense to choose either discount points or lender credits.

What are discount points?

Discount points are fees that you can choose to pay your mortgage lender when you close on your home loan. If you opt to pay points, your lender lowers the interest rate on your loan by a certain amount for each point. Points allow you to pay more upfront in exchange for a lower interest rate and lower monthly payments later.

You'll sometimes hear discount points referred to as mortgage points.

How do discount points work?

A discount point is worth 1% of the total amount you're borrowing. For example, if you're taking out a mortgage for $200,000, each discount point will cost $2,000. And it's possible to buy a fraction of a discount point. So if you pay for 1.75 points that are each worth $2,000, you are paying 1.75 X $2,000 = $3,500 in discount points when you close on your loan.

How much a point will lower your interest rate depends on your lender, but it's typical for one point to reduce the interest rate by 0.25 percentage points.

To understand how your rate will be affected by paying points, start with the lender's baseline interest rate that doesn't take into account any points or credits. This rate is known as the par rate. Then subtract the number of points times the discount each point gives you. 

So if the par rate is 5% and you are buying two points that each lower the rate by 0.25 percentage points, your adjusted interest rate will be 5% - (2 X 0.25%) = 4.5%.

What are lender credits?

Lender credits are like the opposite of discount points. If you decide to accept lender credits, your lender cuts your closing costs by a certain amount for each credit. But at the same time, each credit drives your interest rate higher. Lender credits let you pay less at closing but give you a higher interest rate and higher monthly payments.

Lender credits are sometimes called negative points.

How do lender credits work?

Like discount points, each lender credit is worth 1% of your loan amount. That means on a $200,000 mortgage, one lender credit will reduce your closing costs by $2,000. And you can get a fraction of a lender credit. For example, if one lender credit is worth $2,000 and you take 0.5 credits, then the lender is giving you $2,000 X 0.5 or $1,000 toward closing costs.

For each lender credit you receive, the interest rate you're going to pay on your mortgage goes up. How much the interest rate rises depends on your lender, but as an example, let's say your lender offers one credit for an interest rate increase of 0.25 percentage points. If the baseline interest rate is 5% and you are taking two lender credits, your new, adjusted interest rate will be 5% + (2 x 0.25) = 5.5%.

How do you know if a loan you're considering includes discount points or lender credits?

You can check whether you're offered a loan with discount points, lender credits, or neither by looking at the second page of your Loan Estimate. If you're going to be charged discount points, they'll be listed in Section A along with the positive amount you'll pay for them when you close on the loan. If you're getting lender credits instead, they'll appear in Section J along with a negative amount that shows how much your closing costs are being reduced.

And of course, you can always ask your lender.

What does it mean to break even on discount points or lender credits?

If you buy discount points, you're paying more at closing but enjoying a lower monthly payment later. And if you get lender credits, you're paying less at closing but making higher monthly payments in the future. In both cases, you're making a trade between what you owe now vs. what you'll have to pay going forward. 

To see whether the tradeoff is worth it, you need to find the break-even point, which is when the amount you've saved on your monthly payments equals the extra money you spent at closing (for discount points) or when the extra amount you've paid monthly equals the money you saved at closing (for lender credits).

You can think of the break-even point like balancing a see-saw. Breaking even on discount points goes like this: On the left side of the see-saw is the amount you paid for points at closing. On the right side is the total you've saved so far with lower monthly payments. When you take out the loan, there's nothing on the right side yet, so the see-saw tips toward the left. But as the months go by, your savings add up and the two sides start to even out a little. After a while, the two sides are equal. That's when you break even.

Let's look at some numbers to see how that works. We'll need to divide the money you spend upfront by the monthly savings to find out how many months it will take to break even. Suppose you're spending $1,000 on a discount point, and the lower interest rate you get as a result gives you a monthly payment that's $20 lower. Dividing $1,000 by $20 gives 50, so it will take 50 months, or a little more than four years, to break even on this discount point. 

In other words, if you're going to stay in your new home for longer than 50 months, your savings will outweigh the cost of the discount point. But if you're planning to move after three years, for instance, you will have spent more on the point than you saved during those three years, and the discount point won't benefit you.

The math for lender credits is similar. If you get a $1,000 lender credit in exchange for a monthly payment that's $20 higher, then dividing that lender credit by $20 gives 50. That means after 50 months, your extra payments add up to more than you saved at closing. So accepting this lender credit makes sense only if you're going to sell the home or refinance within 50 months.

When is it a good idea to choose discount points?

It often makes sense to pay for discount points when you plan to stick with a mortgage long enough to break even on them. If you're planning to stay in your new home for many years into the future, paying a little more at closing to cover points could let you enjoy a better interest rate and a lower, more manageable monthly payment for the whole life of your loan. 

If you don't expect to refinance your mortgage to get a lower rate in the foreseeable future — for example, because you think interest rates will go up, or because you'll have less money for closing costs later on — it could be a good idea to buy points now and get the best interest rate you can.

Paying for discount points vs. making a larger down payment

If your mortgage is a conventional loan, discount points are more likely to be a good deal for you if you're making a down payment of at least 20%.

That's because when your down payment hits 20%, you get to avoid paying private mortgage insurance. So if you're currently planning for a down payment that's a bit under 20% and you have extra money to spend at closing, you might be better off using those funds to increase your down payment rather than to buy discount points.

On the other hand, if you're already prepared to put 20% down, it could make sense to spend money on discount points instead of making your already large down payment even bigger. 

Another thing to consider is that making a larger down payment can generally help you score a better interest rate and a lower monthly payment on your mortgage. In some cases, you could save more on interest by increasing your down payment, while in other cases, you'll come out ahead by using that money to pay for points. You may want to ask your lender to show you the interest rate and total interest you'll pay for a loan with a larger down payment and for a loan with discount points so you can compare the two options side-by-side.

When is it a good idea to choose lender credits?

You might benefit from accepting lender credits if you're planning to move again within a few years. If you're going to leave by the break even point, the amount you save on closing costs thanks to the lender credits will be larger than the additional interest you have to pay. 

Similarly, if you expect to refinance before the break even point, it could be smart to take lender credits. You can use the money you aren't spending on closing costs now to get a head start saving up for the closing costs on that refinance.

Lender credits offer flexibility

Another advantage of getting lender credits is that instead of dedicating a hefty sum to closing costs, you can spend that money on other things, like making repairs to your new home or upgrading appliances. 

And lender credits might allow you to make a bigger down payment than you could afford otherwise. Making a larger down payment jumpstarts the process of building equity, and if you're able to push the down payment up to 20% on a conventional loan, you get to skip private mortgage insurance.

Finally, if you're putting off homeownership because you're having trouble coming up with enough money for closing costs, it could be worthwhile to accept lender credits and move forward with purchasing a home. In some situations — like if you need to move to start a new job, or if you've found a house that's perfect for you — you might prefer to seize an opportunity right away instead of waiting until you have more cash on hand.

Discount points and lender credits are two sides of the same coin: Lenders use both to offer you a tradeoff between paying more when you take out your mortgage vs. paying more later. As a result, you may have more options to choose from as you shop for a home loan.

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