For many borrowers, mortgage rates don't quite tell the whole story when it comes to real estate financing costs. In addition to interest, large numbers of borrowers also pay mortgage insurance premiums.
Can you avoid the cost and hassles of mortgage insurance even if you put little down? For many borrowers the answer is yes and the alternative may even be a money-saver.
The Need for Mortgage Insurance
The need for mortgage insurance is not unfair or unreasonable: Lenders do not want to make loans that are nearly 100 percent of a property's value. If they do, they have all the risk if values go down or the property is foreclosed. To limit risk, lenders happily finance 80 percent of a property's value if qualified borrowers put up the 20 percent balance.
Mortgages come in two main types -- conventional (Fannie Mae, Freddie Mac, jumbo, and others) and government (FHA, VA, Rural Housing, etc.). Conventional lenders do not generally fund mortgages exceeding 80 percent of the property value unless they are protected by some form of mortgage insurance. If you get a conventional mortgage with 20 percent down (or refinance with at least 20 percent home equity), there's no need for mortgage insurance.
The problem is that 20 percent down is a lot of money, especially when you consider that borrowers also face closing costs. For instance, the National Association of Realtors says the typical existing home sold for $188,900 in January. For that typical existing home a 20-percent down payment would be equal to $37,780. Add in closing costs and the tab can easily run to $40,000.
Mortgage Insurance and Less Money Down
As an alternative, you can buy a home with a lower down payment if you purchase mortgage insurance. Borrowers can also get conventional loans with five percent down, and those who qualify for Community Homebuyer programs (there are income or geographic limits and other guidelines) can put just three percent down and pay a lower mortgage insurance premium.
Private mortgage insurance (MI) plans vary widely. The cost of mortgage insurance depends on the amount of coverage needed, your loan type and your credit score. Here is an example of one insurer's rate card. The dark green lines represent the cost / coverage typically selected by lenders. So, if you have a credit score of 700 and choose a fixed-rate loan with 10 percent down, your coverage is 25 percent and your cost is .57 percent of your loan amount each year. For a $200,000 mortgage, then, the cost is .0057 * $200,000, which equals $1,140 per year. One twelfth of that, or $95, is added to your monthly payment.
The mortgage insurance rates detailed above apply to conventional (non-government) mortgages only. Government loans are insured by the agencies that back them -- the VA for veteran's mortgages, the USDA for Rural Housing programs and HUD for FHA loans.
- FHA loans require only 3.5 percent down for most borrowers (ten percent for those with lower credit scores). Mortgage insurance premiums -- the MIP -- for FHA loans comes in two forms: An up-front MIP and an annual MIP. The up-front MIP is typically 1.75 percent for new loans but only 0.01 percent for an FHA streamline refinance with loans made before June 2009. The annual FHA MIP varies according to the amount down and the length of the loan. For most new borrowers the annual MIP will be 1.35 percent.
- The VA loan program is a little different: It does not charge mortgage insurance for qualified borrowers but it does have an up-front "funding" fee. The amount of the VA funding fee varies, but for a typical first-time active-duty or veteran VA borrower we're looking at 2.15 percent with no down payment.
- USDA loans combine a two percent funding fee with .4 percent annual premiums (divided by twelve and added to your monthly payment) and require NO down payment. For qualified (lower income) borrowers, USDA loans come with subsidized mortgage rates.
Mortgage insurance is tax deductible for taxpayers who itemize and whose income falls within IRS limits.
Skipping MI: Higher Mortgage Rates
There is a way to avoid paying MI by accepting a higher mortgage rate. While "a higher mortgage rate" is about as popular as the plague, it can be a smarter choice. Imagine that rates today are at 4.3 percent for folks with good credit. Now let's say that a lender offers a conventional loan with five percent down, no mortgage insurance and a rate of 4.55 percent. In effect, the lender is self-insuring the loan and in exchange for a marginally-higher rate is allowing you to borrow with far less than 20 percent down.
It's true that the 4.55 percent rate is higher than you might otherwise be able to get, but it's also true that with the lender's offer there is no up-front MIP, no funding fee and no annual charge for private mortgage insurance. These are big savings for many borrowers. Run the numbers: the monthly cost for a conventional loan without mortgage insurance may well be less than the combined cost of mortgage interest plus insurance.
Will a higher rate work for you? Before dismissing the idea speak with lenders and let them work out the numbers for your situation. How much cash do you need at closing? How much is your monthly payment? Etc. You might be surprised to find that in some cases higher rates are actually a bargain.