A common misconception about buying a house is that a 20% down payment is required.
Lenders prefer 20% down as a form of security so that if the borrower defaults, the lender would at least have 20% of the mortgage paid. The bank can ultimately get the house too, since it’s collateral on the loan, but banks prefer money over possibly losing money on selling a home.
There are plenty of home loans that require as little as 3% down from the buyer, leaving a 17% gap between money paid and what the bank prefers to have.
Mortgage insurance can make up that difference and allow a home shopper to become a home buyer and qualify for a loan.
What is mortgage insurance?
Mortgage insurance is paid for by the home buyer. Lenders often require it before approving a home loan. The higher down payment you have, the less mortgage insurance you’ll need to buy.
If you default on the loan, the mortgage insurance is used to pay the lender up to the insured mortgage amount.
You’d think that buying insurance protects you. But it doesn’t in this case. And this is key. Mortgage insurance protects the lender, not the borrower, against potential losses.
You’re buying mortgage insurance as a way to compensate the lender for taking on the higher risk of lending to you instead of someone with a larger down payment.
There are two main types of mortgage insurance, which we’ll get to soon, but the main one is called private mortgage insurance (PMI) and it typically costs 0.5% to 1% of the entire loan amount on an annual basis.
A 1% PMI fee, for example, on a $100,000 loan is $1,000 per year, or $83.33 per month added to a mortgage.
Costs vary, depending on the down payment, length of the loan, credit score, type of mortgage, and other criteria.
When your equity in the home reaches 20%, you can cancel PMI and no longer have to pay it. That’s the policy of most lenders. Some, however, require PMI to be paid for a certain amount of time, even if you’ve reached the 20% equity threshold.
PMI was tax-deductible until 2017 for some families, but that deduction ended in 2018.
Types of mortgage insurance
Private mortgage insurance is the most common type. It covers conventional mortgages on loans not guaranteed or insured by a government agency. PMI allows down payments as low as 3%.
The second type of mortgage insurance is FHA mortgage insurance premiums, or MIP. It’s for FHA loans, which usually require 3.5% down.
Mortgage insurance can be paid in a few ways:
- A monthly fee paid to your lender (most common)
- Up front as a lump sum
- By your lender (slightly higher interest rate)
- A hybrid of a lump sum and monthly amount
Avoiding mortgage insurance
Paying mortgage insurance can seem like giving money away. It doesn’t help you build equity and it’s not providing you any insurance payout.
Instead, it puts money in the pocket of an insurer and ultimately the lender if you default on the loan.
You can avoid paying mortgage insurance by coming up with a 20% down payment on a home. But that’s very difficult.
One option is to get a piggyback mortgage. It’s a second and smaller mortgage to get you to the 20% down payment. It can work by what’s known as an 80/10/10 agreement:
- 80% of the total property value in the first loan
- 10% in a down payment
- 10% in a piggyback loan
To buy a home for $200,000, that equates to a $160,000 first mortgage, a $20,000 down payment, and a $20,000 piggyback loan.
You pay the second loan back just as you would the first loan.
Some piggyback loans, however, have higher interest rates because they’re considered risky. They increase a buyer’s total loan amount and increase the typical loan-to-value ratio (LTV) of 80% to 90%, exposing the lender to more risk.
Piggyback loans could also be due sooner, such as in 15 or 20 years instead of the standard 30-year mortgage. They may also be adjustable loans or require balloon payments.
Before the housing crisis of the early 2000s, many lenders offered piggyback loans of 20% on top of the first mortgage of 80%. The entire down payment was paid with a second mortgage, allowing the buyer to not have to put any money down.
That changed after the housing crisis when home values dropped and many homeowners found their homes worth less than what they paid for the home. It’s called being underwater on a loan.
Since then, piggyback loans have been limited to 90% LTV, meaning a 10% down payment is required.
Having two loans also requires paying closing costs on two loans, such as origination and administrative fees.
If that is too expensive for you and you don’t want to pay mortgage insurance, your best option may be to wait until you can afford a bigger down payment to buy a house.