Buying a primary home? The 20% down rule is yesterday's news.
More down payment options exist now, including both government and private sector alternatives, allowing more flexible choices for homebuyers.
Don't be fooled however, as most of the programs that allow for less than 20% down include private mortgage insurance (PMI) -- which is an added premium built into the mortgage payment. PMI is meant to protect the lender if you have less than 20% equity in the home and default on your mortgage.
Your PMI is a percentage of the loan amount added to the monthly payment. For example, with conventional mortgages, a loan of $400,000 may carry $166 or so per month in PMI, so that's $166 added to the principal, interest, homeowners insurance and property taxes. And a typical FHA mortgage with a loan amount of $400,000 will carry $450 per month in PMI. (The PMI is higher on FHA loans because they tend to carry lower interest rates, more flexible credit requirements, and lower down payments than conventional loans.)
Either way, that’s quite a bit of money each month. So what should you do if you don't have 20% down to buy a home, and you want to avoid PMI? You have some options.
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1. The Old-School 80/10/10 Method
Popularized in the lending heyday from 2004-2007, the 80/10/10 program allows a buyer to put down just 10% of the purchase price of the home. In most cases, a 10% down payment would require monthly PMI.
Using the 80/10/10 approach, your lender would provide 80% first mortgage, that same lender and/or a subsequent lender would provide a 10% second mortgage in lieu of the monthly PMI, while you contribute the 10% down payment, sealing the deal.
Most lenders will allow for secondary financing up to 90% combined loan-to-value (combined loan-to-value meaning first and second mortgage combined loans) up to the maximum conforming loan limit for the county in which the property is located. While the majority of mortgage lenders typically do not offer second mortgages, smaller pocket-size lenders are entering the marketplace aggressively with the 80/10/10 solution.
You'll likely have to meet at least a 700 credit score requirement and 10% down of your own funds to close escrow. Also, some lenders may even still allow 10% to be gift funds, so check with a qualified mortgage professional.
2. Prepaid Private Mortgage Insurance
Alternatively, rather than electing for the monthly payment option, a buyer with as little as 5% down can chose to prepay the mortgage insurance upfront in a one-time premium called single-pay mortgage insurance.
Not all lenders offer it, so buyers should shop around. The program works by simply pre-paying a chunk of the future PMI payments upfront as a fee at the closing table. This can be anywhere from 1.75% to 3% of the loan amount. Like the 80/10/10 program, a 700 credit score would be required and the single pay mortgage insurance amount can be gifted.
3. Gift of Equity
Do you live in a family-owned property? Or do you have the ability to purchase the property you rent from your landlord? In either instance, the owner of the property -- whether a family member or a landlord -- can provide a gift of equity for at least 5% of the purchase price, as well as for closing costs and single-pay mortgage insurance. A gift of equity is simply the seller of the property providing funds for the benefit of the buyer and accepting less net proceeds at closing. The lender will require a letter of motivation on why the family member or the landlord is selling their property to a buyer with whom they have a personal relationship. There could be a variety of reasons, so it's crucial to make sure the deal is properly reviewed by a qualified mortgage professional. This letter of motivation will address what's called a non-arm's length transaction, when there is a relationship between the buyer and seller. In these situations, the lender places more scrutiny on the transaction due to the potential for fraud .
4. Military Veteran Perks
Do you have previous military experience with a general or honorable discharge? The Department of Veterans Affairs allows eligible veterans with a certificate of eligibility from the VA (which shows their loan eligibility) to purchase a home with no money down as well as no monthly PMI, with loan sizes even as high as $1,050,000 in some high-cost areas.
Eligible veterans will typically pay a 2.15% guarantee fee of the loan amount to the Department of Veterans Affairs, which is added to the loan amount and then re-amortized over the term of the loan. For example, on a loan of $500,000, that's $10,750 added to the loan amount, making the financed loan amount $510,750. That’s still the most attractive option, compared to a PMI premium on another program. If you plan to buy a house in the near future, these possibilities represent a tangible alternative to simply putting down funds and taking PMI on a monthly basis.
While you might elect to do that anyway, PMI -- depending on the loan program -- may be removed in the future. Check with your lender on PMI removal, and how it may apply to your initial down payment and mortgage loan program.
Finally, because credit scores are also an important factor in some of these approaches, it can help to know where you stand and whether you’ll qualify for these programs. Checking your credit in advance of buying a home can help you determine whether you need to take some time to build your credit before applying for a mortgage. You can pull your credit reports for free once a year through AnnualCreditReport.com – and you should check for any errors or problems that are dragging your credit score down. You can also check your credit scores for free through Credit.com, as well as get an overview of what’s affecting your scores and a plan to improve them.
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