A faulty assumption may be keeping you from buying a home.
Nearly 7 in 10 homeowner-wannabes say they are stuck on the renting sidelines because they can’t afford to save up the down payment, according to a 2018 Urban Institute report. About two-thirds of renters surveyed guesstimate they need to make a down payment of at least 15 percent.
They’re way off.
A down payment of just 3 percent to 3.5 percent is typically enough to get a mortgage, assuming you can also jump through a few other qualifying hoops such as having a decent credit score and enough monthly income to handle the mortgage and other debts. (If you are a military veteran, you may qualify for a no down payment loan backed by the Veterans Benefits Administration.)
There are two main sources for low down payment mortgages.
The Federal Housing Administration (FHA) backs mortgages for borrowers who put down at least 3.5 percent. So-called “conventional” mortgages that follow national lending guidelines require a down payment of at least 3 percent. In 2019, the FHA-loan limit is around $315,000 in most regions. The standard loan limit for a conventional mortgage is $484,350. If you live in a high-cost area, the max is $726,525 for both types of loans.
Each program has its own rules of the road, but they both share a common requirement: You must pay for mortgage insurance. Not for you, but for the lender, who is going out on a limb to give you a loan for more than 80 percent of the home’s value.
For FHA-insured loans, the insurance is called the mortgage insurance premium (MIP). For conventional loans, the coverage is called private mortgage insurance (PMI). The cost varies based on a few different moving pieces, but as a ballpark you can expect to pay about $70 a month for every $100,000 borrowed. With both types of loans, the insurance cost is rolled into your mortgage payment.
“There’s sometimes a fear that it’s a bad move to pay for insurance, but the cost is pretty low compared to the return on that investment,” says Tim Lucas, managing editor of The Mortgage Reports. “You can lock in your housing costs today and enjoy future price appreciation as an owner, rather than worry about it as a buyer.”
Lucas recommends working with a lender who offers both FHA-insured loans and conventional loans, and getting cost estimates. A free calculator at HSH.com gins up the cost of an FHA-insured loan, and you can see a side-by-side comparison with a conventional/PMI loan.
Landing on your best low down payment loan depends on these factors:
Private mortgage insurers base their insurance premiums in part on your credit score. If your credit score is at least 740, you may be able to save by choosing a conventional mortgage with PMI, as the annual charge will typically be 0.70 percent of the loan amount or less.
FHA-insured loans charge a flat rate that is not dependent on your credit score. The FHA-fee is either 0.85 percent or 0.80 percent for low down payment loans. The FHA program also tacks on a one-time fee equal to 1.75 percent of the loan amount.
The cost of your mortgage insurance will be less if you foot more than that 3 percent to 3.5 percent minimum down payment. With an FHA-insured mortgage, your annual premium is typically 0.85 percent if your down payment is less than 5 percent, and 0.80 percent if your down payment is 5 percent or more. (In high-cost areas, the premium can be as much as 1.05 percent.)
If you can swing a larger down payment, and you have a solid credit score, PMI becomes even more attractive. The annual premium for a borrower who makes a 10 percent down payment and has a credit score of at least 740 drops to 0.38 percent, less than half the standard charge for an FHA-insured loan.
“If you don’t have great credit and you don’t have at least 5 percent for a down payment, you will likely want to go with FHA,” says Lucas. “With a good credit score and a down payment of 5 percent to 10 percent, you definitely want to check out PMI.”
HSH.com has a calculator that games out different down payment/mortgage insurance scenarios.
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Lenders are laser focused on how much of your gross monthly income you will need to pay this new mortgage plus all your other debts (credit card bills, student loans, and so on). They love it when your debt-to-income ratio (DTI) comes in below 36 percent, but it can stretch to close to 50 percent. Keith Gumbinger, a vice president at mortgage information site HSH.com, notes that if your DTI is above 45 percent it will modestly increase the cost of PMI, but does not impact the cost of the MIP attached to an FHA-insured mortgage. That said, Gumbinger points out that if you are buying a home with someone else, the private mortgage insurers will give you a discount on your premium rate.
Your loan type dictates how long you have to keep paying your mortgage insurance. With a conventional mortgage, the PMI must be canceled when the balance is no more than 78 percent of the home’s value. Lucas cautions that “there is plenty of gray area in how this is calculated by different loan servicers.”
There is no cancellation option with an FHA-insured mortgage. Gumbinger suggests that need not be a deal breaker; the loan may be for 30 years, but if you refinance or move you aren’t going to keep that loan for 30 years.
In the meantime, paying for MIP or PMI can be a reasonable cost if you’re itching to own your own home.