In order to obtain conventional financing, most lenders require a borrower to make a down payment of at least 20% of the purchase price. Fortunately, there are some special programs for first-time homebuyers and for veterans, and not all lenders have the same stringent requirements. However, when shopping for a mortgage, it is important to know what additional costs may be incurred if a hefty down payment is not feasible.
For example, even if a lender waives the 20% down payment requirement, this may mean that the mortgage will cost more than anticipated. Specifically, the mortgages that allow a borrower to finance the purchase of a home without that down payment usually require what is called Private Mortgage Insurance (known as PMI). This is basically an additional premium that gets built into the monthly mortgage payment. The purpose of PMI is to protect the lender. From a lender’s perspective, if a borrower does not have much equity in the home and defaults, the lender suffers greater financial consequences. As a result, PMI is tacked onto the mortgage, and it is usually a percentage of the loan amount that gets added to each monthly payment.
Fortunately, there are ways to say goodbye to PMI even if a borrower is not providing much of a down payment. One way is to obtain two separate mortgages that total about 90% of the purchase price. Obviously, this still requires a down payment of 10%. However, by having one mortgage cover 80% of the purchase price and the other cover the other 10%, it reduces the likelihood of a lender imposing PMI. The key is to read all of the terms and fine print to be sure that both lenders will accept this method. There are so many mortgage options these days that an individual is bound to find two lenders willing to allow it.
Another way to eliminate PMI involves paying down the mortgage. For example, if a borrower obtains one mortgage to finance 90% of a purchase, the lender will more than likely require PMI. However, once the borrower has paid down a certain percentage of the amount borrowed, he or she can contact the lender and have the PMI removed. This usually occurs when a borrower reduces the loan balance by approximately 10%, or reduces the loan to price ratio to 80%. Paying down 10% of a mortgage in a short period of time may seem difficult, but it can actually encourage bigger payments in the beginning, which will attack the principal.
And, depending on the loan amount, 10% may not be that much. For example, for a $200,000 mortgage it is only $20,000. If the additional payments were spread out over the first three years, it would only be about $555 extra per month. PMI can be anywhere from $150 to $600 per month. Even if PMI is required in the first few years, it is ultimately worthwhile to get rid of it as soon as possible. A lot of money could be wasted on PMI for years because the interest portion of a monthly mortgage payment is much greater at the beginning of the prepayment schedule and gradually reduces over the life of the loan while the principal portion is quite small at the beginning and gradually increases over the life of the loan.
Although PMI is an unwelcome added expense, there are ways to avoid it or eliminate it quickly, so please don’t let an insufficient down payment deter a real estate investment! The best thing a prospective buyer can do is research the many options available and come up with a realistic budget.