AlexeyVS/iStock /Getty Images Plus/Getty Images
AlexeyVS/iStock /Getty Images Plus/Getty Images
For homebuyers with less-than-stellar credit who can’t afford to put 20 percent down, mortgages have become more expensive due to a change in private mortgage insurance costs.
“It is more important to have a higher credit score than it used to be,” says Brett Theodos, senior research associate for the Urban Institute, a Washington, D.C.-based think tank that conducts housing policy research.
Lenders are now charging people with low scores more money for low down-payment loans, and giving those with high credit scores a bigger financial break.
Those who put down less than 20 percent on a home are typically viewed as higher risk to lenders since they are believed to have less money than those who can afford to make a larger down payment. For that reason, lenders require homeowners who make small down payments to pay for private mortgage insurance (PMI). If the homeowner foreclosures on the home, the PMI reimburses the lender for the loss.
Mortgage finance company Freddie Mac estimates that PMI costs homeowners between $30 and $70 for every $100,000 borrowed. If a homebuyer purchasing a $200,000 house were to make a 20 percent down payment, he would have to shell out $40,000, plus any closing costs and related fees. However, that same homebuyer could put 3 percent down, or $6,000, by paying private mortgage insurance. Mortgage programs that allow consumers to put down as little as 3 percent often have limits on who can benefit from them. For example, some are only available for first-time homebuyers, while others are only available for people who make less than a certain income.
The high cost of bad credit
Your credit has always impacted how much you pay for PMI, says Derek Brummer, chief risk officer for Radian, a Philadelphia-based private mortgage insurer. Those with good credit pay lower premiums than consumers with lower scores. However, home loan companies Fannie Mae and Freddie Mac, which buy many of the mortgage loans from conventional lenders, recently changed some of their requirements for private mortgage insurers that do business with them. To ensure that mortgage insurers have the money on hand to cover a potential default on a home loan, Fannie Mae and Freddie Mac are requiring them to have more capital on hand when dealing with riskier borrowers. At the same time, private mortgage insurers don’t need as much capital as they used to when insuring less-risky borrowers. To meet those new capital requirements, private mortgage insurers changed how they charged homebuyers for PMI. Riskier borrowers – or those with lower credit scores – pay more in PMI while less risky borrowers – those with higher scores – pay less.
An analysis by the Urban Institute’s Housing Finance Policy Center looked at how those changes would impact a consumer who put down 3.5 percent on a $250,000 home. The analysis found that borrowers with credit scores of 700 and higher would see savings of between $30 and $101 per month on PMI, thanks to the recent changes. On the flip side, borrowers with credit scores between 620 and 639 would find themselves paying $155 more per month for PMI.
While this is good news for homebuyers with the highest credit scores, it makes a home purchase costlier for others. If your credit is in the 600s or lower 700s, you might want to consider the following options:
Look into FHA loans. The Federal Housing Administration (FHA) offers its own version of low down-payment loans that are insured by the federal government. Instead of paying mortgage insurance to a private lender, you would be charged an insurance premium that is rolled into the monthly mortgage payment. With FHA loans, the cost of mortgage insurance is not affected by credit, so you would pay the same rate whether you had a credit score of 760 or 680.
However, there is a major downside to FHA low down-payment loans. With a conventional loan backed by Freddie Mac or Fannie Mae, you can stop paying for mortgage insurance once your home has 20 percent in equity. But with FHA loans, you’re stuck paying the mortgage insurance until the mortgage is paid off. When deciding between an FHA loan or a conventional loan with PMI, “the best thing a person can do is talk to a few lenders about what the pricing is and get a handle on pricing over the life of the loan,” Theodos says.
Work to overhaul your credit. As soon as you start thinking about buying a home, pull your credit report (you can do so for free at annualcreditreport.com). If there is erroneous information such as a charge that isn’t yours, dispute the error with the credit bureaus to clear it up, says Katie Ross, manager of education and development for American Consumer Credit Counseling. If your credit report documents evidence of poor financial management, begin immediately working to resolve those issues. While a FICO score of 760 or higher will qualify you for the lowest rates on PMI, you’ll also do well with a 720 or above, Brummer says.
Put more money down. If you can afford to make a 20 percent down payment, you will not have to pay PMI at all. However, even if you can’t put down 20 percent, there’s a benefit to putting down, say, 10 percent over 3 percent. The interest rate you’re charged for PMI is higher the less money you put down. “If someone’s only putting 3 percent down, they're going to pay more than someone who puts 10 percent down,” Brummer says.
When you take charge of your credit, you end up with more options when it’s time to make major financial moves such as buying a house. “Your creditworthiness is key in the home buying process, and you want to position yourself as a good risk to any lender that looks at your application,” Ross says.