Most people already know that unless they purchase their home with at least 20 percent down, they’ll probably have to buy mortgage insurance. However, almost no one knows that there are money-saving alternatives available.
The purpose of mortgage insurance is to reduce the cost to lenders if borrowers end up in foreclosure. According to the Mortgage Bankers Association, foreclosures cost lenders “30 to 60 percent of the outstanding loan balance.” It’s obvious, then, that a small down payment won’t do much to offset this loss. And without insurance, lenders might not be willing to provide loans to buyers who have smaller down payments.
What Is Private Mortgage Insurance?
Private mortgage insurance (PMI) is for conventional (non-government) mortgages. Applicants must be approved by both the mortgage lender and the mortgage insurer. The cost for coverage depends on your down payment, the mortgage program, your credit score and the type of coverage you choose. The most common option is a monthly premium. It’s less costly at the outset, and it can be canceled when your loan balance drops to 80 percent of the home’s purchase price. Premiums are calculated by using an annual rate, and then dividing by 12. Annual rates are usually about 1 to 2 percent of the outstanding principal amount of the loan.
Another option is a single premium policy, which can be purchased upfront by the borrower, lender, agent, builder or seller. There is also a split premium option, which combines a smaller upfront payment with a smaller monthly payment. Ideally, you’d get the seller to pay the single premium when you negotiate your home purchase. Even if you pay it yourself, however, it may be less expensive than monthly charges.
Lastly, lender-paid PMI may also be an option. The lender may purchase coverage from an insurer and then charge you a higher interest rate, or they may charge you the higher rate to self-insure. The disadvantage is that you can’t cancel lender-paid PMI. However, it may provide a better tax write-off for those with higher incomes.
Federal Housing Administration (FHA), Veterans Affairs (VA) and U.S. Department of Agriculture (USDA) home loans are backed by the government, and also require insurance coverage. VA loan insurance is called a “funding fee,” which is a single premium that can be paid upfront or wrapped into the loan balance. Funding fees range from 1.25 percent for a first-time user putting 10 percent down, to 3.3 percent for a repeat user putting nothing down.
FHA mortgages have both an upfront premium (1.75 percent as of this writing), and an annual premium that’s divided by 12 and added to your monthly payment. It varies from .45 percent for a 15-year mortgage with 10 percent down and a loan amount that doesn’t exceed $625,500, to 1.05 percent for a loan exceeding $625,500 with less than 5 percent down. Unlike PMI, FHA insurance cannot ever be canceled, and is required for all FHA loans regardless of the loan-to-value ratio.
How to Pay Less
When shopping for a home loan, don’t leave mortgage insurance out of the equation. This cost can have a huge impact on the total price of your loan, and not all lenders disclose it the same way. You may also want to consider a purchase money second mortgage, which is also called a piggy back, to decrease your first mortgage to 80 percent and eliminate the need for home loan insurance. Finally, increasing your down payment and improving your credit score can lead to lower PMI rates.
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