Do you really need to save 20% for your mortgage down payment?

Since the recession, there’s been considerable uncertainty around the minimum needed for a down payment. Do you need a full 20% down payment now to qualify? That’s a big chunk of change….what if you could put less down?

Unfortunately (fortunately?), since the recession, lenders are very careful about giving out loans. If you can put down 20%, you should. Not only is it the best financial move, but it also will help you in a bidding war in today’s hot sellers’ market. But we’ll leave it to Redfin to give you the full details on that in a later post!

From a purely financial standpoint, if you want a traditional loan that’s not funded by the Federal Housing Authority (FHA), you will need to put 20% down to avoid paying private mortgage loan insurance (PMI). PMI is required when the home buyer puts less than 20% down, and not all financial institutions offer it as an option. Other lenders are comfortable with smaller down payments. We at Alliant Credit Union, for instance, offer mortgages with as little as 3% down with PMI.

PMI was created to protect the lender in case of homebuyer default, particularly when the homebuyer is not yet heavily invested in the property (has a low down payment) and has more incentive to walk away from the mortgage. As for exactly how much you’ll pay, PMI rates vary depending on the size of the down payment and the loan, ranging from 0.3% to 1.15%.

Real life PMI example

How does this translate to real dollars? Let’s say fictional first-time home buyers Beyoncé and Jay-Z are considering a house for $250,000 and can scrape together a 10% down payment. In other words, they are paying $25,000 and asking to borrow $225,000. Meanwhile, their mortgage insurer charges 0.51% PMI.

The insurer multiplies the loan amount ($225K) by 0.51% (.0051) for the annual loan premium of $1,147.50. This is then divided by 12, for a monthly payment of $95.63. If that seems high, keep in mind that PMI payments are tax deductible, at least through 2015 (consult your friendly tax advisor further about this). Ah, small wins.

Important PMI note

Legally, you should only be paying the PMI until you own 20% of the property. Federal law requires lenders to tell the buyer at closing how many years/months until that will occur (set up that calendar alert!). Once you reach that point, you will need to pay for a new appraisal, but it will be worth it. Lenders must automatically cancel the PMI when the lender’s balance hits 78% – but you can cancel when it gets to 80%, so that’s an extra 2% you could pay if you aren’t mindful.

Are FHAs worth it?

An alternative to the traditional loan is a loan backed by FHA (Federal Housing Authority). The FHA isn’t a lender in itself – but rather an insurance fund. The governmental organization was created to help buyers with weak credit or buyers who can’t manage a 20% down payment. But the FHA option has changed significantly since 2008.

YES! FHA Loan Upsides:

  • The FHA guarantees home loans
    – Doing so reduces the risk to lenders and offers increased borrowing power to qualified applicants. 
  • FHA loans are viable options for those who can’t afford a 20% down payment AND/OR have weak credit. 
    – You can currently get an FHA loan if your credit score is 580 or higher – and pay only a 3.5% down payment. 
    – Home buyers with credit scores between 500-579 will need to be able to pay a 10% down-payment, according to BankRate.com.
    – Sellers, builders or lenders can pay FHA loan closing costs of up to 6% – for a price. If your lender pays the closing costs, your loan rate will be higher.

Nope. FHA loan downsides:

  • You will need to pay an upfront mortgage insurance premium of 1.75% of the loan amount. That’s nearly $4,000 on a $225,000 mortgage loan. This cost is added to the principle balance of the loan, increasing the overall loan amount. 
  • You will also need to pay an annual insurance mortgage premium. But as of January 2015, the FHA reduced the price on a 30-year fixed FHA loan from 1.35% to 0.85% of the loan balance.

Saving for a mortgage down payment may not be the easiest thing you’ll do in your life – but it shouldn’t be the hardest either. If you’re having trouble, definitely talk to your local lender, who can likely help – or at least refer you to a group that can. Meanwhile, stay tuned next time for when we cover the full costs of home ownership.