What is a Principal Reduction?
A principal reduction happens in some unique situations where there is too much credit. If the lender gives a $4000 credit, but the total closing costs are $3500, the lender still has to give you that $500 difference. Lenders aren’t able to adjust the loan amount because this could impact your equity. Instead, lenders use that extra $500 as a principal reduction. The lender typically applies the principal reduction within 2-3 months after closing.
So your initial loan amount is still the same and your payments are still based on the initial loan amount. However, shortly after closing, your balance will drop by the amount of the principal reduction. You may be able to pay off your loan slightly sooner. Since you owe less it would also help you if you decide to sell before paying off the loan. The principal reduction shows up as a charge against the borrower since it’s collected at closing.
Why are they more common with ‘borrower paid transactions’?
In borrower-paid transactions, the lender can still give a credit to the borrower, but it cannot be applied directly towards the origination fee since the borrower is supposed to pay that. Let’s say we assume $3000 in origination fees and $2000 in other closing costs. If there is a $4000 credit, a principal reduction comes in to play. The $4000 can only be used for the closing costs, so there is $2000 left over. In the case of a refinance, many times borrowers decide to roll the $3000 origination fee into the loan, and get the $2000 principal reduction.
While it’s unique concept to grasp, a principal reduction on a borrower paid transaction is usually a good thing because all costs are being covered. There are some limits of how much a principal reduction can be based on the loan.
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