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Mortgage rates have been dropping for the past few months, with a 30-year fixed falling to 4% recently according to FreddieMac. And now there’s the possibility that the Fed will lower interest rates again this fall. So this could be the ideal time to buy that home you’ve been eyeing.
But suppose you have credit problems or haven’t saved enough for a hefty downpayment (20% for most conventional loans)?
Data from U.S. Mortgage Insurers (USMI) revealed that it could take 20 years for a household earning the national median income of $61,372 to save 20%, plus closing costs, for a $262,250 home, the median sales price for a single-family home in 2018.
And by the time you do, housing prices may have substantially increased to the point of becoming out of reach. In other words … it’s like trying to hit a moving target.
The reality is that banks are reluctant to trust potential borrowers who have poor credit or can’t invest much of their own money in a home. They want assurance that you’re a good risk and can be trusted. And in their eyes, the lower the down payment the riskier the loan.
Moreover, coming up with a 20% down payment can be a humongous hurdle for first-time buyers who don’t have much in savings or any equity in a current home.
But lack of cash doesn’t mean you can’t achieve the American Dream …
How Private Mortgage Insurance (PMI) Bridges the Gap
PMI protects the lender in case the borrower defaults on the mortgage.
The premium is based on your credit score, the loan-to-value ratio (LTV) of the home, and whether the mortgage will be fixed or variable rate.
The better your credit, the lower the premium. Another good reason to build good credit.
The LTV ratio is the amount you want to borrow compared to the value of the home securing the loan.
For example, if you hope to borrow $180,000 for a $200,000 home, the ratio would be: $180,000 ÷ $200,000 = 90%.
But if you can come up with more cash and only need to borrow $170,000, the ratio becomes: $170,000 ÷ $200,000 = 85%.
So as far as the lender is concerned, the lower the ratio … the less risk in making the loan.
The Important 78% Mark
PMI isn’t cheap. Typically it costs 0.3% to 1.5% of the original mortgage amount each year. That means PMI at 1% for a $180,000 loan could cost you $1,800 per year, or $150 per month. The lender tacks this premium to your monthly payment.
So you want to get rid of it as soon as possible.
As you make mortgage payments the amount you owe slowly declines and your equity rises.
When the LTV falls to 80%, you can ask your lender to drop PMI. However, they are not required to do so.
But once it hits 78% (you have 22% equity in the home) they must eliminate the insurance.
So in the above example, when the mortgage drops to $156,000, the LTV falls to 78% and would be canceled.
There are several ways to reach this mark sooner:
- Get a new appraisal. It’ll cost you a few hundred dollars, but if your home has surged in value, the additional equity could push the LTV down to the 78% mark. For instance in our example, if the home’s value shot up to $240,000 and you owed $175,000, the LTV would be 73% … low enough to request that the PMI be dropped.
- The same could apply if you remodel. A new screen room or upgraded kitchen, for instance, could make your home more valuable.
- Pay a little extra each month and tell your lender to put that money towards the principal … not interest. $50, $75, $100 or so on top of your regular mortgage payment will get your loan balance down faster.
Lenders must tell you at closing how many years it will take until your mortgage is paid down enough to cancel PMI. So be sure you understand where this information is located in the loan documents.
The Downsides…
Before you sign up for PMI realize that there are some important details that the lender might overlook explaining to you in full.
For instance,
- PMI does nothing to protect you if you can’t make the payments
- Premiums are not tax-deductible
- You might have to pay the first year’s premium at closing
- The lender is the beneficiary. Your loved ones get nothing if you die
- Reaching the 78% mark could take many years
On top of all that, it could take months to cancel the coverage once you do hit the 78% mark …
Your request must be in writing. The lender may want a certified appraisal, which you might
have to pay for, to assure the home’s value hasn’t fallen below the original estimate. They’ll also request proof that there aren’t any other debts on the property, like a home equity loan or second mortgage.
How to Avoid PMI
There’s really no way to shop around for PMI. You have to accept what the lender offers. But you aren’t without options …
You could take out a piggyback mortgage to get you enough money for a 20% downpayment.
Suppose you want to buy a home for $200,000 but only have $20,000 for a down payment.
You’d take out two separate loans for the same home. The first would be for $160,000 representing 80% of the home’s value. The second loan would be for 10%, which is $20,000.
This is also known as an 80/10/10 loan. The first mortgage is for 80% of the home’s value. You’re putting down 10%. And the second mortgage covers the remaining 10%.
Even though you won’t have PMI premiums to pay, there could be other costs that might make this strategy more expensive.
- There will be closing costs on two mortgages, rather than one
- The second loan will probably have a higher interest rate than the first
- The second loan will typically be variable, which could mean an even higher interest rate in the future
- The second loan might have a balloon provision that makes it payable in full in 15 or 20 years
- The second loan doesn’t go away until you pay it off, whereas PMI gets canceled at some point
- Some lenders will not permit you to borrow down payments.
There are other alternatives to conventional PMI.
For instance:
- The FHA has loans with a 3.5% down payment and provides its own mortgage insurance
- Your local or state government might have down payment programs
- The VA has special low-downpayment loans that don’t require mortgage insurance
In 2018, PMI helped more than 1 million borrowers purchase or refinance a home with an average down payment of 7% and as small as 3%.
Without this insurance they would have been kept from living the American Dream.
And as long as you understand the ins and outs and are willing to pay a little extra money each month, PMI could make it possible for you to buy your dream home too.
To a richer life,
Nilus Mattive
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