If you are buying your first home, it is a wise suggestion that you are able to deposit a 20% down payment. Anything less than that amount down and you may be required to obtain Private Mortgage Insurance (PMI). This insurance assures your lender that they will be compensated in the event that you default on your loan. About 1 in 3 homebuyers need to secure a PMI.
It may seem that Private Mortgage Insurance may be a good alternative if you are unable to come up with a 20% down payment at the time of purchasing your new home. Keep in mind though that this insurance can be expensive and the rates you receive are based on the amount of your down payment and your credit score. Generally the more you borrow and the lower your credit score the higher your monthly PMI will be.
If your loan company requires that you obtain a PMI, you will need to keep it attached to your mortgage for approximately two years. If after the two year period you have accrued 25% equity, you will be able to drop the insurance. However, after five years you are only required an equity of 20%. At the time that you feel you are able to drop your PMI you must have your lender order an appraisal of your home. This is needed to confirm your home’s market price.
Under the Federal Homeowners Protection Act your mortgage lender is required to drop this added insurance if you have reduced what you owe on your home to 78% of the original purchase price. This applies even if your home has lost market value. However, if your loan was considered high risk, this does not apply. You will also receive an annual notice from your lender that reminds you that you are able to cancel under these conditions. Keep in mind that a second mortgage or a home equity loan will reduce your home’s equity. The two government agencies that actually regulate how much down payment is needed is Fannie Mae and Freddie Mac because so many times lenders sell loans to them.
So why is having to get PMI a bad idea? It has already been stated that PMI can be costly depending on your down payment and your credit score. The average price of a home is $230,000. Most PMI rates are between .5% and 1% of the annual cost of the loan. This could mean you can easily be paying another $200 a month!
Another possible disadvantage may be that you may not be able to use it as a tax deduction. Private Mortgage Insurance can be deducted only if the married taxpayer earns less than $110,000 and for couples that file separately the limit is $55,000. That amount might go up in the future, but being that there are no guarantees of that happening, a larger down payment would make more sense. All that interest on the loan could be deducted.
As stated earlier, a homeowner that achieves an equity of 20%, no longer needs PMI and can cancel. Sometimes, however, this can be a difficult task. For one thing, this may take as many as 7 years to achieve. And as stated earlier you may need a formal appraisal to satisfy the lender. Also some lenders require a formal letter sent to them from the homeowner. This can all be aggravating and time consuming.
Another issue that may happen is that the lender may require the homeowner to keep the insurance for an extended period of time despite the fact that the equity may be available.
Be sure to question your lender and always make sure to read the fine print on your contract.
On the other hand of course a large number of homeowners are able to deduct their PMI. An example with a 250,000 loan and a PMI of 1% or an annual payment of 2,500 would give a break of about $300 to $400.
You may also be able to pay your PMI upfront. Depending on your lender you may even be eligible for a discount if you pay at the time of the mortgage inception. Another option is you may be allowed to pay the cost over the life of the loan which could greatly diminish your monthly payments.
Another little ray of sunshine may be that once the PMI is removed from your monthly payments, you will have a little more pocket change. This may make you at least feel a bit better and you may be able to invest the savings.
The bottom line is, if you are trying to buy your first home, your best bet is to have a 20% down payment. Private Mortgage Insurance is not a terrible option, but you would be much better off to keep your money in your pocket.