An Expert Explains How to Sidestep Mortgage Insurance With Less Than 20 Down

An Expert Explains How to Sidestep Mortgage Insurance With Less Than 20 Down

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If you have less than 20 percent of the purchase price to put down on your new home, you can use one loan and pay mortgage insurance, or use two loans to avoid mortgage insurance. There are advantages and downsides to each.

If you put 20 percent or more down on a home, the lender has little risk because statistically you are less likely to default. If you do default, there should be plenty of equity in the home to pay off the loan if the lender forecloses.

If you put less than 20 percent down, the risks to the lender rise, so it takes out an insurance policy called mortgage insurance. This is a policy paid for by you, the borrower. It pays back the lender for a portion of its losses in the event that you default and the lender has to foreclose.

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This enables the lender to make loans at higher loan-to-value ratios so you can purchase a home with less down. It obviously costs you a little more money, however.

The good news is that defaults and foreclosures are way down in the last couple of years, so the cost of mortgage insurance has been falling. In fact, for those with very good credit and at least 10 percent down, the cost has fallen by about half in the last year. The amount you pay will still vary greatly and is heavily dependent on your loan-to-value ratio, the size of your loan and your credit score and history.

You can avoid mortgage insurance by putting 20 percent down, but that’s not feasible for everyone. You can also avoid paying mortgage insurance by using two loans: a first mortgage that is 80 percent of the purchase price or less and a second loan to make up the difference between the first mortgage and your available down payment.

The second mortgage could be a conventional, fully amortized loan or an equity line. The advantage to a conventional loan is that your interest rate and your monthly payment can be fixed and paid off in equal installments over time (typically either 15 or 30 years). Equity lines always carry variable interest rates, but the advantage is that you can pay it down as fast as you wish and then draw the money back out should you need to access it in the future.

The good news is that defaults and foreclosures are way down in the last couple of years, so the cost of mortgage insurance has been falling.

How does the math work out? Let’s assume we have a $250,000 purchase price and 10 percent down. We can use one mortgage for $225,000 and pay mortgage insurance, or use a $200,000 first mortgage and a $25,000 second as either a loan or an equity line. Here’s what that looks like:

(Note: We assume excellent credit and qualified borrower. Rates change without notice and your experience may be different. Example for illustration only.)

 

One Loan Plus MI First Mortgage Plus Loan First Mortgage Plus Equity Line
First Mortgage: $225,000 $200,000 $200,000
Interest Rate: 4.250% 4.250% 4.250%
Payment (P&I) $1,106.86 $983.88 $983.88
Mortgage Ins.: $150 (estimated) $0 $0
Second Mortgage: $0 $25,000 $25,000
Interest Rate: NA 6.000% 6.000%
Payment: $0 $149.89 $125.00 (interest only)
Total Payment: $1,256.86 $1,133.77 $1,108.88

Before you get too excited about the low payment on the equity line, note that the minimum payment is interest only. You will make no progress on your principal, and eventually you’ll have to make much higher payments if you don’t pay more in the early years.

Your choice should match your circumstances. Which one is right for you?

Mortgage insurance can be removed after two years if you have more than 20 percent equity based on a current appraisal, or is automatically removed when your loan balance reaches 78 percent of your original purchase price. If you are putting 10 to 15 percent down and you expect the property to appreciate or plan to invest some sweat equity that will increase the value, using one loan is a good choice because after two years you can simply make the mortgage insurance payment go away.

If you expect your income to be stable or only rise a bit over the next few years and don’t match the description above, use two loans but use the fixed second for your second mortgage. The equity line’s interest rate is variable, and you may or may not be able to handle an increase in the payment if that happens.

If you have windfall income, such as bonuses or stock options, or expect your income to rise sharply, use two loans and use the equity line, because you are likely to be able to pay it off quickly. If the interest rate rises, your payment won’t rise much because you’ll have paid it down, and you can access the equity again if you need it.

The important thing is to choose the solution that best matches your needs and goals.