What used to be an insider secret, substantial Lender Credits are becoming more and more common.
This is an article about Lender Credits—what they are, how to use them, some background information on how they’ve evolved, and very detailed examples on how they work—therefore it is lengthy. Here’s a quick snapshot on Lender Credits if that is what you’re looking for: A Lender Credit is money that the bank or mortgage company gives you, the home loan borrower, for taking a higher rate. If your note rate goes up, the bank makes more profit on providing your mortgage, and Lender Credits are some bank’s way of sharing that with you to offset the costs and fees of a mortgage loan.
We’ve said it time and time again on this blog: the world has changed. You don’t need me to count the ways, you can see it all around you. If you are in sales or work for a retail company, you’ve no doubt heard the echoing cries from all corners, “the millennials are taking over, we have to learn how to reach them!”. It’s true that when generations turn over—when the bulk of those making financial decisions are no longer in an older generation, but have been overtaken by the next—it brings with it new trends, new mantras, new ways of doing business. You either adapt or get left behind.
Lender Credits, commonly known also as Rate Credits or Premium Pricing, are a trend that Joel and I were out in front of back in 2008. Back then, the unraveling economy was creating less certainty for our clients, and we looked for ways to protect them. Lender Credits was one of those ways, and it worked by shifting the risk of an uncertain rate environment from the client to the lender, investor and servicer.
It’s a simple thing really, but I’ll go into the profound affect it actually has when you start to apply it.
Most financial instruments pit short term gain vs. long term gains, risk vs. reward, savings vs. certainty, etc. There is always a tradeoff. One very well know example is the lottery. Everyone knows that if you win the jackpot, you have to choose between getting ALL of your millions slowly over 20 year or settling for only PART of your winnings now—more money vs. more instant gratification is the tradeoff.
To a much less exciting effect, “points” on a mortgage are the same concept, and Lender Credits are essentially negative points. If you are paying points, you have chosen (or were asked) to pay an upfront cost to “buy down” your interest rate. You are electing to pay more today to save over the life of your loan. This methodology used to be the prevailing practice. Why would you choose to do this? Well, if you knew, just KNEW, that you weren’t ever going to move, refinance, get divorced, or take cash out of your home, then the loan you bought your home with would be the loan you kept. In that case, it would make sense, for example, to pay 1% of your loan amount up front to save 0.25% every single year.
Like I keep saying, though, the world as changed. Many of us homeowners have refinanced several times since 2008. I’ve moved twice in that time too, and I plan to move again in 2020. No longer is our first home also our last home, nor do we have the certainty that a better mortgage deal won’t come along someday.
Again, Lender Credits are the opposite of points, or negative points. You can choose, most of the time, to elect to pay a higher interest rate and have the bank give you an upfront credit to offset the cost of doing your loan. The amount of the credits you can achieve is dependent on many factors that affect pricing: loan to value ratio, credit score, etc. It is also dependent on the day, because much like a stock price, the amount of credit (expressed as a negative percentage of the loan) varies with the market and with the supply and demand of the given note rate. Today, for example, the VA 30 Year Fixed for a given set of qualifications may be 3.25% with -1.0 points, but if “rates go up” tomorrow the pairing may look like 3.25% with -0.75 points instead, and you would have lost access to the difference of 0.25% of credits.
The best way to see the impact is to look at an example. This is a real example, but it happened 7 years ago, a little after I first introduced this concept to my clientele, and the names have obviously been removed. The way this works is no different now, despite everything changing around it.
I had a client that always wanted to make sure he had the lowest rate in his family. He had several siblings that ran a business together, and there was some strange sense of pride surrounding boasting the best financing terms. Part way through our first of many refinances together, his wife announced a pregnancy, and he wanted to back out of the transaction because they were already talking about needing more space after the baby was born—he thought they might move in a year. He was paying 5.5% back then, and the rate he was refinancing to was 4.5%. I congratulated him, and told him not to worry, I could still save him money doing a “Freefi”, the cute little branding term I used to use to describe offering a rate that came with enough credits to cover all of the added cost of refinancing.
Note: This term, Freefi, no longer meets an approved standard, because it implies the loan will be free, and since you pay interest, the loan is not free…I simply meant the transaction was free because we were covering the costs, and since people were already paying interest—at a higher rate no less—they got the point...nonetheless, I no longer use that term. The concept lives on, we just changed the name to something that offends regulators less.
Let’s look at how it works (I’ve rounded the numbers for ease of following).
He owed $400,000 @ 5.5%.
- Total Lender costs were $1000.
- Total Title costs were $2000.
- Prepaid and escrow deposits were around $3000.
- He had the ability to get 4.5% with 0 points.
- Or, he had the ability to get 4.75% with -0.75 points, or a credit equal to 0.75% of his loan amount, $400,000, equaling $3000.
- Bottom line, he could move down from 5.5% to 4.75% without incurring any added cost of refinancing* since the Premium Rate Credit I could offer was equal to the added cost of refinancing.
* added cost of refinancing is the way I describe the cost you actually incur because you have chosen to refinance. Interest, taxes, insurance, etc. are all cost you are already paying because if you are refinancing, by definition, you already own a home and have a mortgage. Therefore, even if you don’t refinance, you still pay them. He would still have to deposit money into his new escrow account, but he would also get refunded the amount currently in his escrow account, and since all of these items represent things he will pay whether or not he refinances, they are irrelevant.
At first, he was skeptical.
He said, “Mike, if I move in a year, there is no way I can recoup the cost of refinancing. What if I move sooner?”
I replied, “Sir, you sure can recoup the cost if I make sure there is no cost of refinancing”
Him: “I don’t see the benefit of only going down ¾ of a percent, I heard you have to save 1% to make it worth it.”
Me: “You have two choices, pay 5.5% for free, or pay 4.75% for free*. The latter saves you $2200 in the next 12 months. The former earns you nothing. You sure?”
*Again, we now know this doesn’t meet regulator definition of the word “free”.
We did a lot of business together over the years.
While this is one example, there are many reasons and uses for Lender Credits. They are a very simple concept, the tricky part is that they change daily, and do not move linearly, which means you cannot assume a standard amount of credit will appear for each tick in interest rate. For example, today you might be able to get 0.5% credit for accepting a .125% higher rate, but only a 0.75% credit if go up another 0.125% (0.25% total) from par (par = the “zero-point rate”). There are diminishing returns to protect the bank against you making too much money up front and never actually paying any of the interest. You need to find the “sweet spot” in the rate sheet that makes the most sense. Here is an example of a 30 Year Fixed Rate chart, rate vs. credits, that was really available on a given day in the recent past (for those who qualified), just to give you an idea ($330,000 Loan):
This is a great illustration of why knowing this is so important to your financial situation. Looking above, you could have chosen to pay 1.5 points (or $4950 on top of all other closing costs) to get 3.25%, or you can take a 1.875 point CREDIT ($6188) and accept the higher rate of 3.75%. The difference in monthly payment is only $92, while the difference in upfront cost is $11,138! It would take you 121 months to recoup that huge initial difference one monthly payment at a time, and that’s over 10 years. And this ignores the time-value of money principal, which exacerbates the difference.
At this point, it is important to note, that while I explained that escrow deposits and interest due are not costs that are introduced only because you are refinancing, they can be covered by Lender Credits. These credits can cover all closing costs, any tax or insurance due at closing, recording fees, and any tax or insurance deposits going into an escrow account, but it cannot cover things like your Realtor’s commission, or apply to principal (except in rare cases), or pay your mortgage payment. Knowing what it does cover is important, because it is a huge bonus for you, the consumer, and is a way you can actually “make money” on the loan in a roundabout way.
Think of it this way, any money that the bank pays on your behalf to someone that you would have had to pay anyway, while at the same time providing you a lower interest rate than what you had, is a net gain to you from a cash perspective. We call it “creating cash”.
Here is a side by side example of this in action. Let’s use a $300,000 VA Loan at 4% this time, and explore a hypothetical refinance scenario. On the left is a traditional, regular cost refinance, and on the right is one that takes advantage of lender credits effectively.
Seeing the options side by side should illustrate the difference for you, and drilling down to a breakeven can help you determine if getting a lower rate or getting more in lender credits makes more sense for you. Ignoring time-value of money (an economic principal that indicates money now is actually worth more than money later due to inflation and opportunity cost), it would take you 109 months, just over 9 years, before taking the lower rate outweighed taking the higher credit trade-off. In my opinion, 10 years is always too long to wait to breakeven, but given your own set of plans and goals, you may disagree, and that’s fine! But now you know, and you know what they say about that.