The days of needing a 20% down payment to buy a home are long gone. However, if you do buy a home with less than 20% down, lenders want you to pay private mortgage insurance.
Private mortgage insurance (PMI) is an extra fee your mortgage lender will normally require you to pay each month if you have less than 20% equity in the home. The fee is typically based on approximately 0.5% of the loan amount on an annualized basis, but other factors change this amount. If you have a conventional loan (non-FHA/VA loan), a main driver of PMI cost is your credit score: The higher your score, the lower your PMI. Your down payment amount is also a factor — for example, you'll pay more in mortgage insurance on a 10%-down loan than on a 15%-down loan. More skin in the game equals lower cost for the borrower.
However, there is a way to buy a home with less than 20% down and avoid the dreaded PMI.
Shift the Burden to the Mortgage Company
PMI can be paid by the lender instead, under a program called Lender Paid Mortgage Insurance (LPMI). The catch: You'll have to pay a slightly higher interest rate than the current market rate. However, it could lower your mortgage payment by several hundred dollars every month.
Let's take a look at the math.
When paying the PMI yourself: Let's say you take out a loan of $417,000 at 90% financing and a fixed interest rate of 4.375%. The annual mortgage insurance is $2,502 per year based on 0.6% of the loan amount and your credit score. This adds $208.50 per month to your mortgage payment – for a total monthly payment of $2,290 (not including taxes or homeowner insurance).
With lender-paid PMI: Alternatively, for a $417,000 loan, trading the monthly PMI fee for a slightly higher interest rate at 4.625%, the mortgage payment drops to $2,144, giving you a $146 lower monthly payment. The total lower monthly mortgage payment can also improve your borrowing power by lowering the payment-to-income ratio, a key measure lenders use in determining how much house you can afford. Keep in mind that taking lender-paid PMI means you'll pay more in interest charges over the life of the loan.
In order to qualify for lender-paid PMI, lenders want the following:
- Borrower should be buying a primary home
- At least a 700 credit score
- A 10% down payment
- A payment-to-income ratio not exceeding 45%
Can You Avoid PMI Down the Road?
Mortgage insurance was once tax-deductible on a primary residence, but it no longer is, which may inspire some borrowers to take the higher interest rate instead.
Additionally, removing PMI down the road without refinancing is not for the faint of heart. First, you'll need to have had the PMI on your loan for the past 24 months and have accumulated 20% equity just to be eligible. Assuming you've met those thresholds, it is a petition with your lender/servicer to drop the mortgage insurance, it is by no means a guarantee. Make no mistake, your lender, to whom you're making your mortgage payment, is not incentivized to contact you, to drop the monthly premium you're paying that only enriches their balance sheet. The onus is on you, the consumer, to get it removed.
Refinancing is always an option to drop mortgage insurance as well. In many cases, the fees you'd pay for refinancing very well could be less than the total 24-month cost of the mortgage insurance you would otherwise need to show for your petition to remove PMI.
If you have the cash for 10% down, Lender Paid Mortgage Insurance may be a favorable loan choice. It more than likely will provide a lower monthly mortgage payment with a larger buying power all while possibly avoiding future hoop-jumping with your lender in two years or having to refinance.
Before you start looking for a home, it's important to make sure your credit is in as good shape as possible – because your credit not only determines what interest rate you'll get, but it's also a factor in how much PMI you'll pay. Review your credit reports for errors or other issues that are dragging down your credit scores, and pull your credit scores to get an idea of where you stand. (You can get your credit reports for free once a year from each of the major credit reporting agencies, and you can get two free scores updated monthly on Credit.com.) Of course, be sure to work closely with your lender to come up with the best plan to work on any credit issues ahead of applying for a mortgage.
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