Home buyers who don’t have enough for the customary 20% down payment at closing will often resort to finding creative ways to avoid paying Private Mortgage Insurance or PMI. While there are a variety of different solutions that allow you to buy a home with the less than 20% down and still avoid paying PMI, depending on the program you choose, they may or may not be more expensive in the long run.
It’s important to consider the costs, benefits and any future trade-offs that these options present before you buy your next home with less than 20% down. We dive into some of the most popular ways to avoid PMI on your home purchase and run through the costs and benefits of each approach.
- What is PMI and How Much Does it Cost?
- How To Avoid Paying PMI on Your New Home Loan?
What is PMI and How Much Does it Cost?
PMI is a type of insurance policy required by lenders to protect themselves from borrowers who default on their loans. Private mortgage insurance differs from homeowner’s insurance in that it’s not for your protection. The insurance is meant to decrease the lender’s risk of non-payment from borrowers, especially if the homeowner doesn’t own much equity in the property. Lenders will generally pass this cost on to the borrower.
For most conventional mortgages, the minimum loan-to-value threshold where PMI is required stands at 80% and above. How much PMI will cost you will depend on the following traits:
- loan amount
- credit score
- size of your initial down payment (Your LTV)
Rates for PMI range from 0.3% to 1.65% of the initial loan amount and are charged each year, typically as a monthly premium. Generally, you can expect your PMI expense to increase with how much you owe on your home. The greater your loan amount, the higher your PMI.
- For example, on a $300,000 mortgage, borrowers can expect PMI to cost anywhere between $900 and $4,950 a year, or $75 to $412.50 per month, depending on your credit profile and equity stake.
- For a $100,000 mortgage, PMI usually costs between $300 and $1,650 a year, or $25 to $137.50 per month.
Mortgage insurance companies take your credit score into account when determining your PMI. The better your credit score is, the less expensive your PMI will be.
- On a $300,000 mortgage, credit scores of 640 could have PMI costs of $412.50 and credit scores of 740 would have PMI costs of $175 per month. That’s a difference of about $237 per month.
Size of Your Down Payment
Finally, the greater your down payment, the less your PMI will be. So, if you plan on putting less than 20% down on a home purchase, it’s still a good idea to try to scrape together as you can comfortably afford.
- PMI costs typically jump at 85.1%, 90.1% and 95.1% loan-to-value levels.
- On a $300,000 mortgage at 86% loan-to-value and a 720 credit score, the PMI would cost around $115 per month, and at a 96% loan-to-value, the PMI would cost $217.50 per month—a difference of $102.50.
Luckily, there a number of options out there that subsidize or eliminate the need for PMI altogether. Some of these options cost more than others, and a few may cost even more than if you decided to stick with making PMI payments until you hit the required 20% level to remove it. You’ll need to weigh the pros and cons of each approach carefully.
How To Avoid Paying PMI on Your New Home Loan?
There are several ways to avoid paying PMI on home purchases without having to put 20% down. These range from government assistance programs that reduce the amount you have to put down up front to shared financing agreements that allow home buyers to trade the future appreciation in their home for an up-front loan.
Fannie Mae HomeReady
Fannie Mae's HomeReady program offers reduced mortgage insurance premiums for qualified low- to moderate-income home buyers and features the following:
- Minimum 3% down payment
- Only 25% of your LTV needs to be covered by PMI, which is lower than standard PMI coverage levels of 30% on loan-to-value ratios of 90.01%-95% and 35% for loan-to-value ratios of 95.01%-97% that apply to most loans.
Freddie Mac HomePossible
Freddie Mac's HomePossible program provides reduced mortgage insurance premiums for qualified home buyers, including both first-time or repeat buyers. The program requirements are listed below:
- Minimum 3% down payment
- Minimum 25% PMI coverage, which is below the standard 35% coverage required for down payments of less than 5%.
State- and Local Government-Sponsored Mortgage Programs
Local governments often offer their own down payment assistance and subsidies for qualifying first-time home buyers. The specific benefits offered may vary by program, but they all reduce the size of the down payment needed by the home buyer. Here are some of the most common program types.
- Grants for first-time or struggling home buyers. These can contribute as much as $3,000 to $10,000 to your closing costs or down payment. They do not need to be repaid.
- Short-term down payment loans that are either paid back or forgiven over time. The rates on these loans are often at or below your existing mortgage rate. These can eliminate the need for PMI but may require repayment if you sell your home.
- First-time home buyer savings accounts. These allow home buyers to save for a down payment on a tax-advantaged basis, similar to a 401(k) or IRA account. Proceeds may be capped but can be dedicated toward qualifying down payments or closing costs.
One example is the MI Mortgage or MI Flex Mortgage offered by the Michigan State Housing Development Authority (MSHDA). This program offers up to $7,500 in down payment grants to qualifying buyers purchasing a home in a designated area.
Down payment assistance programs represent a powerful way for aspiring home buyers to achieve homeownership while having your down payment subsidized by public authorities. Check with your local government or housing finance agency to see what programs might be available.
Lender Paid Mortgage Insurance
Lender paid mortgage insurance (LPMI) allows you to avoid monthly PMI payments in exchange for a higher interest rate on your loan. Lenders generally fold the cost of PMI into the loan pricing so that separate premiums aren’t required. This is usually in the form of a higher interest rate.
Most lenders have strict credit score requirements for LPMI programs, with average and lower scores requiring higher interest rates. It’s likely that only those with excellent credit might avoid being penalized under these programs.
You may actually end up paying more over the life of the loan with LPMI due to the higher rate from the lender. Even worse, you can’t reduce the interest rate on a mortgage with LPMI without refinancing, even after you reach 80% loan-to-value. Your higher rate will stay with you for the life of the loan.
Consider the following scenarios for a $300,000 loan amount on a 30-year term with 95% loan-to-value:
|Monthly Premium||0%||0.58% or $145*|
|Monthly Payment (P&I)||$1,564.94||$1,475.82|
|Total Monthly Payment||$1,564.94||$1,620.82|
|Total Loan Repayment||$563,379.12||$561,149.55|
The LPMI option in the example above has an interest rate that is half a percent higher than a loan with borrower paid mortgage insurance. Initially, the monthly payments are $55.88 lower with the LPMI program. However, after 8 years, the PMI can be dropped once your equity reaches 20%; this will lower your payments from that point on.
With LPMI, your interest rate and monthly payment will remain at the same inflated level for as long as the mortgage remains outstanding, substantially increasing the cost of your loan.
Piggyback financing consists of a primary mortgage and a secondary form of financing, either in the form of a home equity loan or line of credit (HELOC). The most common is the 80/10/10 loan, which refers to a home ownership structure that consists of the following:
- 80% loan-to-value first mortgage
- 10% loan-to-value secondary loan
- 10% down payment
Under this structure, instead of paying PMI, you secure both a mortgage and a home equity loan with their own rates and terms, and end up making payments to two loans instead of one. Ideally, the combined monthly payments would cost less than if you took out a single mortgage with PMI.
The obvious downside is that home equity products generally have higher interest rates than first mortgages. It’s often the case that the additional interest expense paid on these loans does not justify the cost of avoiding PMI. It may also be difficult to find a lender willing to finance a 10% home equity loan on top of an already over-leveraged property.
Shared Appreciation Mortgages
Shared appreciation mortgages (SAMs) allow you to avoid PMI by allowing an investor to contribute part of your down payment in exchange for a percentage of your home’s future appreciation. This serves the dual purpose of reducing your monthly payments and avoiding costs up front.
SAMs can trade PMI payments in the short term for a stake in your home’s anticipated appreciation. They also can reduce or eliminate the need for a substantial down payment on your part and can even allow you to cash out equity to use for home repairs or other needs. This makes them ideal for home flippers and real estate investors.
The downside of taking on a SAM to avoid PMI is that if your property significantly increases in value, you may end up paying more in the proportional equity gain when you sell the home than you would have on the original PMI payments. These may also have substantial fees included.
Sometimes the best option may be to wait until you have enough for a 20% down payment, as it is often the most cost effective strategy in the long run. You’ll avoid PMI without paying higher interest rates for LPMI or surrendering a portion of your future equity gains via a shared appreciation loan.
Unless you’re concerned about being priced out of a particularly hot real estate market, or interest rates begin to climb rapidly, it may not be the right time for you to move forward with purchasing a home.
Making a preemptive purchase you can't afford could increase your monthly payments to unmanageable levels. Even if you anticipate a pay raise over the next year or two, at best you'll likely face a cash crunch in the short run, and at worst you could put yourself at risk of foreclosure. Waiting until you’re financially capable of buying a home can save you significant amounts in interest expense and fees.