“You need at least a 20 percent down payment if you want to buy a home.”
Sound familiar? If you’ve been thinking about buying your first home, you’ve probably heard that bit of wisdom a time or two (or 12). But is it true?
Not necessarily. It’s absolutely possible to get approved for a mortgage and buy a home with less than 20 percent down. But… there’s a catch.
Buying a home with less than 20 percent down may mean paying private mortgage insurance.
What is private mortgage insurance (PMI)?
Private mortgage insurance, or PMI, is an insurance policy for your lender. You get homeowner’s insurance to protect your investment; the lender has PMI to protect theirs.
Only borrowers with conventional loans (a.k.a. any mortgage that’s not part of a government program) are eligible for PMI. FHA and USDA loans have their own mortgage insurance requirements; Veterans Administration loans let you sidestep mortgage insurance altogether.
How does PMI impact your home buying costs?
How you pay PMI depends on how your loan is structured. You may pay one single premium when you buy your home, a monthly premium — or both. Single premiums can be paid in cash or rolled into your loan at closing. Monthly premiums are added on to your principal and interest.
Ultimately, you’ll need to do the math to see whether it’s worth it to pay PMI.
Say you want to buy a $300,000 home. You diligently saved (give yourself a big pat on the back!), socking away the $60,000 you needed to make a 20 percent down payment and locking in a 30-year mortgage with a 4.46 percent interest rate. Your estimated monthly payment, including principal, interest, property taxes, and homeowner’s insurance comes to $1,523.
Or you could put down just 5 percent, or $15,000, instead. In theory, a smaller down payment could put less stress on your cash flow. But once you factor in PMI, your monthly payment climbs to $1,929 — a difference of more than $400 each month.
Does it ever make sense to get PMI?
Some homeowners want to avoid a higher monthly house payment at all costs. But for others, it can be worth it.
But, there’s a trade-off you have to consider. If you’re looking at a $300,000 home, $60,000 isn’t exactly chump change. According to Zillow, saving a for a down payment is the biggest roadblock to owning a home for two-thirds of would-be buyers. It could take you years to save up a 20 percent down payment.
Getting a mortgage with less money down removes that obstacle so you can become a homeowner sooner. The key is making sure that your monthly budget can handle the higher payments. There’s light at the end of the tunnel, though — PMI doesn’t last forever.
With a conventional loan, you can ask your lender to cancel your PMI once you reach 20 percent equity in the home. And even if you don’t make the request, the lender is legally required to cancel PMI once you reach 22 percent equity, or if you hit the midway mark of your loan term.
The only time you might not be able to cancel mortgage insurance is if you have an FHA (Federal Housing Administration) or USDA (United States Department of Agriculture) loan. Those premiums stick around for up to eleven years.
Paying PMI could keep you in the black.
Even if you have enough to put down 20 percent on a home, that doesn’t necessarily make it the right move.
If putting down 20 percent would wipe out all your cash reserves and leave you with nothing set aside for emergencies, you could find yourself in a pinch if you need to replace your roof or repair your HVAC system unexpectedly.
In the worst-case scenario, you could end up turning to credit cards to cover major repairs, or smaller emergencies. Now you’ve got your monthly mortgage payment, plus payments to credit cards to worry about, and no savings.
Paying PMI means a higher mortgage payment but it could help you preserve any cash cushion you have and avoid adding new debt.
Review all your home buying options.
A conventional loan with 20 percent down isn’t the only way to buy a home and if you’re still feeling iffy about paying PMI, it helps to compare what’s out there before applying for a mortgage.
FHA loans, for example, allow qualified buyers to get a mortgage with as little as 3.5 percent. For veterans, servicemembers on active duty, and certain Reservists and National Guard members, VA loans are another option to explore.
USDA loans require zero down but there are special conditions you have to meet to qualify, such as living in a rural area and not making more than the income limit allowed for your family size. A VA loan could be a great option if you’re a veteran but these loans tend to require buyers to jump through more hoops with the appraisal and inspection than other mortgage types.
There’s also the HomeReady loan program from Fannie Mae. This program, which Ally Home partners with, lets you buy a home with as little as 3 percent down. While you will pay PMI for a HomeReady loan, the premiums may be less than what you’d pay for a conventional loan. That could be a good compromise if you’re worried about PMI pushing your monthly mortgage payments into unaffordable territory.