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You do the math, then check the balance in your savings account, and then do the math again. By your calculations, it’ll take another three, maybe five (!) years to save enough for a 20% down payment on your first home. What’s worse, home prices keep rising, and that’s pushing the timeline further away. If only there was a way to make it happen sooner and use the money you’ve already saved.
The good news is there are loan options that allow home buyers to make less than the traditional 20% down payment. These loans each carry an additional cost to the borrower to cover the mortgage insurance premium, but that’s not a bad thing at all. We’ll talk about mortgage insurance, but first, let’s look at the benefit of using a low down payment loan option.
The sooner you buy, the sooner you’ll begin to accumulate equity (i.e., wealth) by regularly paying down your principal each month and through average appreciation of the property’s value. Add that to the tax benefits from the mortgage interest, and the importance of purchasing a home sooner rather than later begins to grow.
If you take advantage of one of these loans, you can get past what looked like the burden of mortgage insurance and see the value of homeownership. Finding the right option for your financial situation is accomplished by going through a complete analysis of your income and credit with a lender.
Before you do that, review the details, benefits, and drawbacks outlined in this blog post about the most common alternatives to making a 20% down payment.
First, you need to understand a little more about mortgage insurance — a policy benefiting the lender if a borrower fails to repay their mortgage. The borrower is required to pay the premiums for the mortgage insurance policy, which is either government or private insurance.
Government mortgage insurance applies to the following loans:
- FHA – available to any borrower purchasing a home they plan on occupying as their primary residence. Also available for refinancing loans.
- VA – (Veterans Affairs) available for US military veterans, active duty, or reservists for purchase or refinance loans.
- USDA – available with income restrictions (for low and moderate-income borrowers) and for properties located in rural areas.
Private Mortgage Insurance (PMI) applies for conventional, non-government insured loans, which includes:
- Fannie Mae – “Home Ready” loan for conforming loan amounts.
- Freddie Mac – “Home Possible” loans for conforming loan amounts.
- High Balance Conforming loans – for loan amounts above conforming to the maximum allowed for high balance conforming.
There are a few benefits that make FHA loans attractive for borrowers, including a minimum down payment as low as 3.5%. Also, you don’t have to be a first-time homebuyer to be eligible and you can purchase or refinance a primary residence for loan amounts up to a maximum of $970,800 (in high-cost areas), with fixed-rate mortgages (ARM). The base loan limit for all counties is $420,680 for 2022.
The drawback for FHA loans is the mortgage insurance (MI) premiums. The Federal Housing Administration, an agency of the U.S. Department of Housing and Urban Development, provides the MI and requires it for the life of the loan (if you are making a <10% down payment). Regardless of the loan balance or the amount of equity in the property, MI continues unless you refinance into a conventional loan, sell your home, or otherwise pay the balance in full.
FHA MI premiums are the highest among the low down payment options, with 1.75% of the loan amount as an upfront premium, and monthly premiums varying from .45% to 1.05% of the loan amount. Most borrowers finance the upfront premium by adding it to the loan balance, and the monthly premium will depend on the term of the loan (15 or 30 years), your loan amount, and loan-to-value (LTV).
USDA loans are another low down payment option allowing loans up to 100% of your purchase price. These loans, made by mortgage lenders to low to moderate-income borrowers buying a property in a rural area, are guaranteed by the US Department of Agriculture. To find out if your income qualifies in the area you’re looking for, go through the analysis on the USDA site here. You can also check USDA-eligible rural areas here.
The MI premium for USDA loans is 1% of the loan amount upfront, added to the loan balance, and an annual premium of .35% of the loan balance. As you pay down the loan, the annual premium is reduced.
The final government option is a VA loan, and it’s available for active and retired military and reservists. Veterans receive a Certificate of Eligibility from the Department of Veteran Affairs, which allows up to 100% financing without monthly MI premiums. There is a one-time funding fee collected when the loan closes, which varies from 1.25% to 3.3% depending on the down payment and the veteran’s eligibility.
VA loans can be used to finance your primary residence at the time of purchase or for subsequent refinances.
Non-government insured, conventional loans with low down payment options are also available. Conventional loans, made by mortgage lenders, are sold to government-sponsored enterprises (GSE’s) after they close. The two GSE’s, Fannie Mae and Freddie Mac will purchase loans with as little as 3% down payments as long as they carry private mortgage insurance (PMI).
Fannie Mae has the Home Ready mortgage available for borrowers with income equal to 100% of their specific area median income, which can be determined here. You don’t have to be a first-time buyer to qualify, but you do have to take a homeownership education course before closing a Home Ready mortgage and use it to buy your primary residence.
Freddie Mac’s Home Possible mortgage is similar to Fannie Mae’s version, allowing a minimum down payment of 3% and requiring a homeownership education course. Both loans have flexible guidelines and will use the rent from a roommate or rental income from a Mother-in-law unit to help in qualifying.
Fannie and Freddie require PMI when the equity in a home is less than 20%. PMI premiums are lower than FHA premiums, with the actual cost varying based on loan-to-value (LTV). A significant benefit, compared to government MI, is the ability to cancel the mortgage insurance once your LTV falls below 78% without having to refinance, sell or pay off your mortgage.
You’ll need a minimum credit score of 640 to qualify for conforming loan amounts (maximum of $647,200) and 660 for high balance loan amounts (maximum of $970,800). You’ll also need to pay closing costs for your purchase, but you can use credit from the seller or lender, or use gift funds from family to pay them. Lender credits occur when you accept a higher interest rate.
If you have enough savings to put 10% down on a purchase, you can use piggyback financing and avoid PMI entirely. Piggyback loans refer to combining a first mortgage (conventional) with a second mortgage that piggybacks on the first mortgage. The combination of the two loans equals up to 90% of the purchase price.
Piggyback loans have steeper credit score requirements, a 730 minimum, and can require you to have assets available after the loan closes as reserves. The reserve requirement will vary based on your loan amount but can equal 6-12 months of your full housing payment (mortgage + property tax + hazard insurance premium + HOA Dues).
You can use a piggyback loan when your purchase requires a jumbo loan amount. Loans up to a combined maximum amount of $1,700,000 will allow you to finance a purchase price of up to $1,888,888. You’d need to make a 10% down payment, $188,889, and get a first mortgage for 80% of the purchase price ($1,511,110) and a second mortgage for 10% ($188,889). Jumbo loans are loan amounts of $970,800 and higher.
With all the options available, from government loans to conventional conforming and jumbo, you can stop waiting to make your home buying dream come true.