By Elizabeth Blessing, Wealth of Geeks
According to Freddie Mac, mortgage rates are rising again with the 30-year fixed-rate mortgage average leaping to 4.48% this week. But higher interest rates could pale in comparison to the additional cost you could pay if your home loan requires private mortgage insurance (PMI).
PMI is a cost of homeownership that surprises many first-time homebuyers; one that's easy to overlook in the excitement of going through the homebuying process. For the unprepared homebuyer, the cost of paying PMI can be a real budget-buster, adding thousands of dollars in additional expense every year.
Fortunately, with a bit of planning and knowledge, you can avoid paying PMI.
What is private mortgage insurance (PMI)?
The purpose of private mortgage insurance is to protect the lender if you default on your mortgage. If you cannot put a minimum 20% down payment on a conventional home loan, your lender will likely require you to pay PMI.
The advantage of PMI for homebuyers is that it allows them to buy a home without paying a complete 20% down payment. On the face of it, this might seem like a huge plus, saving the homebuyer from having to fork out tens of thousands of dollars upfront and still enabling them to buy a home.
But if you do your research before you buy your home, you might find the actual cost of PMI far outweighs its benefits.
How much could PMI cost me each year?
Again, it's important to emphasize that PMI is insurance that the homeowner pays that protects the lender, not the homeowner. PMI does not swoop in and make your payments for you if you fail to make your mortgage payments.
Instead, PMI provides the lender with some protection if the homeowner defaults on the loan and the house goes into foreclosure. The thinking behind PMI is that if the lender needs to sell the foreclosed home at auction to recoup its money, it will (according to foreclosure statistics) recover on average about 80% of the home value, and the other 20% will be covered through the PMI policy.
PMI premiums can be hefty, generally ranging from 0.55% to 2.25% of your original loan amount. How much you'll pay depends on factors like your down payment amount and your credit score.
For example, if your PMI is 2% and your loan amount is $250,000, you'll pay $5,000 a year. Most people opt to pay PMI in monthly installments, which means you'll pay about $416 a month in this scenario. This payment is on top of your mortgage payments, property taxes, homeowner's insurance, and home maintenance costs.
Keep in mind this is not a one-time fee, but an expense that you'll need to pay as long as the equity you have in your home is below 20%.
Five ways to save money and avoid paying PMI
Given how costly PMI can be, it's no wonder many homebuyers are eager to avoid the expense. Here are five ways you can avoid paying PMI.
1. Shop around for a loan that doesn't require PMI
Look for alternative loan programs that either waive the PMI requirement or give you down payment assistance. For example, VA loans don't require PMI, so you could save a bundle if you qualify. Look into loans insured by the Federal Housing Administration (FHA) or the U.S. Department of Agriculture (USDA). Both agencies have programs to make homeownership more affordable for low- and moderate-income buyers.
2. Check out state and local homebuyer assistance programs
More communities are making affordable housing a priority, including developing new programs designed to assist home buyers. Some communities focus on "workforce housing," which targets making homeownership affordable for people with certain occupations, such as school teachers, firefighters, or first responders. You can get started by checking out HUD's local homebuying page for programs in your state.
3. Look for an 80-10-10 loan
One strategy to avoid PMI involves getting an 80/10/10 loan where you put 10% down and take out a 10% home equity line of credit and use that to satisfy the 20% down payment requirement, says Eric Simonson, founder of Abundo Wealth. The line of credit will likely be variable so you will want to prioritize paying that off sooner, Simonson says. If you're unsure how to find a lender that offers 80/10/10 loans, check with your accountant or financial advisor who can likely offer recommendations.
4. Pay a higher interest rate
Some lenders offer loans that allow you to avoid paying PMI in exchange for a higher interest rate. You'll need to go through a qualification process, but you'll be allowed to put down less than 20% if approved. Your monthly mortgage payment will be higher-in some cases substantially so-because you'll be charged a higher interest rate.
5. Buy a less expensive home
Just because you're pre-approved by a lender for a certain amount doesn't mean you need to max out that amount when you purchase your home.
"I generally don't recommend using PMI to buy a bigger home that stretches your finances, since any hiccup in your life could make your mortgage harder to pay and introduce a lot of stress," says Stanley Himeno-Okamoto, founder of DRS Financial Partners.
A savvier approach for a first-time homebuyer might be to buy a "starter home," a less expensive one that they can comfortably afford without having to incur PMI.
A Final Thought
Perhaps the most obvious solution to the PMI dilemma is to reconsider buying a home until you're able to put 20% down, thereby avoiding PMI entirely. While this might delay your homeownership dreams for some time, it might also provide you with an opportunity to take a step back and consider if now is the best time for you to take on the responsibility and expense of homeownership.
Read more: 3 Home Buying Myths You Shouldn't Fall Victim To
Waiting until you've saved enough money to buy a home with 20% down will put you in a stronger financial position to negotiate better terms with lenders. It will also allow you to carefully weigh all your options before making what will probably be one of the most important purchases of your life.
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