Jack M. Guttentag The Mortgage Professor

When You Have to Purchase Mortgage Insurance

My understanding is that, if a home buyer puts 20 percent down, he doesn't have to purchase mortgage insurance. I put 20 percent down -- $48,000 on a $240,000 home purchase - but I'm told that I do have to buy mortgage insurance because I elected to finance $6,000 in settlement costs, making the loan $198,000 instead of $192,000. Why is this?

You are confusing the amount of cash you put into the transaction with the down payment. The down payment is smaller because of settlement costs.

In dollars, the down payment is the difference between property value and loan amount. In your case, the value of $240,000 less the loan of $198,000 leaves just $42,000 for the down payment. That is 17.5 percent of property value, so you must purchase mortgage insurance.

In percent, the down payment is also 1 minus the LTV (loan-to-value) minus the ratio of loan to value. In your case, the loan of $198,000 is 82.5 percent of the value of $240,000, and 1 minus 0.825 is 0.175, or 17.5 percent.

On a purchase transaction, "financing settlement costs" has no meaning because it amounts to exactly the same thing as paying the settlement costs in cash and borrowing a larger part of the sale price. If you paid the $6,000 in cash out of your $48,000, you would have required the same loan of $198,000.

To avoid this type of confusion, mortgage insurance requirements and many underwriting rules are based on the LTV rather than the down payment. Mortgage insurance is required when the LTV is higher than 80 percent. This is the same as requiring insurance when the down payment is less than 20 percent, but it avoids any confusion about what constitutes a down payment.

On a refinance transaction, financing settlement costs is meaningful because it results in a larger loan than would have been the case otherwise. For example, if several years down the road, when your loan balance is $190,000, you decide to refinance, the new loan could be for $190,000, or it could be for $190,000 plus the settlement costs. But note that whether or not you have to pay for mortgage insurance on the new loan will depend on whether the new loan amount, inclusive of settlement costs or not, is more or less than 80 percent of property value at that time.

Appraisal Versus Sale Price

I managed to buy a house for $200,000 that has been appraised for $245,000. Can the difference of $45,000 be counted as my down payment?

No. The rule is that the property value used in determining the down payment and the LTV is the sale price or appraised value, whichever is lower. The only exception to this is when the seller provides a gift of equity to the buyer, who is almost always a family member in this situation. In this case, the lender recognizes that the house is being priced below market and will accept the appraisal as the value. Most lenders in such cases will require two appraisals, and they will take the lower of the two.

Using Land as a Down Payment

We own a piece of land and plan to build a house on it. In this case, can we use the land as the down payment?

Yes. If you have held the land for awhile, the lender will appraise the completed house on your lot, and the difference between the appraisal and the cost of construction will be viewed as the down payment.

For example, if the builder charges you $160,000 for the house and the appraisal comes in at $200,000, the land is assumed to be worth $40,000. A loan of $160,000 in this case would have a down payment of 20 percent, or an LTV of 80 percent.

If you purchased the land recently, however, the lender will not value it for more than you paid. If you paid only $30,000, for example, the lender will value it at $30,000, and your down payment will only be 15.8 percent.