The 20% down payment myth is driven by the fact that borrowers must pay PMI when obtaining a conventional loan with less than 20% down. Many home buyers want to avoid the added monthly PMI cost. I personally think that PMI is an effective tool to help some people buy homes sooner. I recently had a friend refer his adult daughter to me. When I counseled her to make a 5% down payment and pay the monthly PMI, Dad challenged me. Here’s how I explained it to him.
His daughter wanted to buy a $200,000 house and had about $25,000 of savings. A 5% down payment was $10,000 and a 20% down payment was $40,000. Remember that a home buyer must pay closing costs and prepaid escrow at closing, in addition to the down payment. And I always recommend that buyers keep cash available in a bank account after closing, to provide a “reserve” should an emergency arise.
The $10,000 down payment left her with $15,000 for closing costs, prepaid escrow, and her “emergency fund.”
To avoid PMI, she would need to save another $25,000 or more for the 20% down payment. I asked Dad how long it would take her to save that and he said 5 to 10 years. I then told Dad that with Anna’s great credit score and 5% down payment, her PMI cost would be less than $60 per month.
She could stop paying rent and buy a house now in a rapidly appreciating home market. Paying PMI to buy now would enable her to build equity as home prices rise, rather than just continuing to save more and more to keep up with rising home prices while she rented and saved (not to mention that a $200,000 home today is no longer going to be a $200,000 home in the 5-10 year time frame it would take to save up 20%).
And current interest rates are near historic lows. There’s no way to predict now what future interest rates would be when she finally saved enough to pay 20% down.
When I explained the math, her dad agreed and she bought a home with a 5% down payment.
Note that PMI premiums are calculated based on the down payment amount and the borrower’s credit score. In general, the lower the down payment, the higher the PMI premium. And in general, the lower the borrower’s credit score, the higher the PMI premium. So not everyone will have such a clear choice as Anna did. But for borrowers with good to great credit scores, my opinion is that paying mortgage insurance is often better for building wealth than paying rent and waiting to save the full 20%.
Do you know someone in Georgia who fears they are “missing out” as they rent while home values rise rapidly? If yes, please connect them with me. I’ll work to help them buy sooner with a mortgage that best fits their need, with as small of a down payment as possible.
I know I posted this information about a year ago, but I hear this myth so often in the mortgage market, I will keep repeating this…..You do NOT need 20% down to buy a home!
According to recent National Association of REALTORS data, the average down payment made by recent home buyers is 12%. Younger buyers tend to put down less. Buyers between age 22 and 30 made an average 6% down payment. Recent home buyers between age 31 and 40 made an average 10% down payment. This ultimately follows common sense, as younger buyers have had less time in the work force to save for a down payment.
Veterans using VA mortgage financing can obtain loans with a 0% down. FHA mortgages have a 3.5% down payment requirement. And borrowers can obtain conventional mortgages with only 3% down.
The 20% down myth is driven by the fact that borrowers must pay PMI when obtaining a conventional loan with less than 20% down. Many home buyers want to avoid the added PMI cost in their monthly payment. But I personally think that PMI is an effective tool to help people buy homes and build wealth sooner. I recently had a friend refer his adult daughter to me. When I counseled her to make a 5% down payment and pay the monthly PMI, Dad challenged me. He did not want her to pay PMI. In my next blog post, I’ll explain my PMI response to Dad. Spoiler alert….the daughter did by a house with 5% down and paying PMI – it made very good financial sense.
Do you know a friend or family member who wants to buy a home in Georgia? Don’t let them by discouraged by the 20% down myth. Tell them that is only a myth and then connect them with me. It is very possible that I can help them finance a home purchase sooner, instead of waiting to save more money. We will work to make their home ownership dreams a reality – hopefully right now.
A recent National Association of Realtors (NAR) economist blog noted that 24% of first-time home buyers obtained FHA financing in January, while 59% obtained conventional mortgage financing. This is very interesting as it contrasts the picture painted in my blog post from September 2019. That post noted that 75% of Millennial home buyers obtained FHA financing. While not all first-time home buyers are Millennials, the recent data still appears to be a significant change from only about 18 months ago.
FHA mortgages once attracted many first time home buyers with a 3.5% minimum down payment. But beginning in 2014, home buyers could obtain conventional loans with only a 3% down payment. FHA loans also appeal to home buyers with lower qualifying credit scores. Conventional interest rate pricing charges higher interest rates for lower credit scores. Because FHA pricing places less emphasis on the borrower’s credit score than conventional loans, FHA pricing was often more attractive to buyers with credit scores less than 700, especially when those buyers could only make a small down payment.
Note that “standard” conventional loans with a 3% down payment require the borrower to pay a higher interest rate and mortgage insurance premium as compared to 5% (or more) down conventional loans. But conventional mortgage giants Fannie Mae and Freddie Mac began offering special loan programs (called Home Ready and Home Possible, respectively) to home buyers whose annual income falls below a threshold (currently about $65,000 in the Atlanta area) and with credit scores of 680+. With these programs, 3% down conventional loans become very competitive with FHA loans for buyers who qualify.
When a buyer qualifies for the Home Ready / Home Possible program discounts, they can save money in two ways as compared to FHA financing. First of all, conventional loans do not require up-front mortgage insurance. FHA loans require a 1.75% up front mortgage insurance premium that is typically rolled into the loan amount. Secondly, when the borrower’s equity reaches 20%, the conventional loan mortgage insurance can be cancelled, even when the borrower initially made only a 3% down payment. Borrowers who use FHA mortgages with less than a 10% down payment must pay monthly mortgage insurance premiums for as long as they own the mortgage. The monthly FHA insurance premium is 0.85 for all loans with less than 10% down payments. That is about $177 per month on at $250,000 mortgage. The fact that such a large insurance premium is permanent makes many buyers consider conventional loans more favorably.
Are you considering your first home purchase? Be sure to explore all the loan programs available to you, including conventional and FHA mortgages. Give me a call and I’ll help you compare your options to determine which will give you the lowest total payment, considering both the interest rate and the mortgage insurance components.
As discussed previously, using an FHA loan to buy a home makes sense for home buyers with relatively low credit scores and limited down payment funds. FHA loans offer very attractive pricing for these home buyers.
Interest rates have now fallen to their lowest level in three years, so it may be time for current FHA mortgage holders to consider a conventional mortgage refinance. The interest rate savings may not be huge, but changing from FHA mortgage insurance to private mortgage insurance could bring significant financial benefits.
I’m working with a couple now (we’ll call them Jack and Diane) who bought their home in 2017. At that time, their qualifying credit score was in the mid-600’s and they had just enough cash for the FHA minimum down payment. This was an ideal scenario for an FHA mortgage.
Fast forward to 2019 – their credit scores have increased and home appreciation in their neighborhood has given them more equity. A conventional loan now makes sense for their updated situation. They can refinance to a new interest rate that is just 0.25% less than their current rate. Normally such a small monthly savings, by itself, does not justify the cost of refinancing.
In addition to the interest rate savings, they will also save money every month with lower mortgage insurance payments. Switching from their FHA loan to a conventional loan will lower the mortgage insurance monthly premiums by about $120. Their total monthly savings equal $160, and their refinance has a break-even point of just over two years. Considering the interest rate savings plus the mortgage insurance savings makes their refinance worthwhile.
An added benefit is that their new private mortgage insurance will cancel in a few years (unlike the FHA insurance which is permanent), increasing their monthly savings to about $200. So, Jack and Diane will realize this bonus savings in just a few years.
Ultimately, home buyers who used an FHA loan two or three years ago may reap big rewards from a conventional refinance now, assuming their property value has increased.
Ron moved into your neighborhood in the last three years or so. At the neighborhood Halloween party, ask Ron if he has heard of an FHA mortgage. If he replies, “Yes, that’s the type of loan I have,” ask him if he would like to lower his monthly payment. Then connect Ron with me. We will quickly determine whether moving to a conventional mortgage can help Ron financially.
There are some interesting facts and observations in an August article documenting survey results from Millennial home buyers. Here’s a link to the full study from lendedu.com. 1,000 people aged 23 to 38 participated in the survey. Here are some survey results:
58% of respondents say they own their own home.
83% of these home owners obtained a mortgage to buy their home.
75% of these mortgage holders obtained a FHA loan.
16% is the average down payment percentage for the survey respondents.
To me, it is very surprising to me that such a high percentage of these home buyers used the FHA program, especially given the relatively high down payment percentage reported. What I also find surprising is how the author treats FHA loans vis a vis the private mortgage insurance component of conventional mortgages.
Let’s look at the basics of FHA mortgage insurance (“MI”) vs. conventional (private) mortgage insurance (“PMI”). FHA charges a 1.75% up-front MI. On a $300,000 loan, that charge is $5,250. Assuming a Millennial average 16% down payment, FHA charges a 0.80% monthly MI premium, which equals $200 per month. And for this loan, the borrower must pay the monthly MI for 11 years.
For PMI on conventional loans, there is no up-front fee. So our $300,000 mortgage holder is better off by $5,250 to start. The PMI premium is based on the combination of down payment and the borrower’s credit score. Let’s assume that a Millennial buyer (we’ll call her “Anna”) has a 680 credit score. I calculate Anna’s monthly PMI premium at 0.26% or $65 per month. In addition, the conventional loan PMI will cancel sooner than FHA MI, so Anna will pay conventional loan PMI for less than half the time she would pay FHA loan MI.
Summarizing this example, Anna with a 680 credit score would reap the following mortgage insurance benefits of choosing a conventional loan vs. FHA: (1) Anna saves $5,250 by not having the up-front FHA MI premium rolled into the loan amount; (2) Anna saves $135 per month with the lower PMI rate vs. the FHA MI rate; and (3) Anna stops making mortgage insurance payments way sooner. And Anna’s PMI payment will be even lower if her credit score is in the 700’s. From a mortgage insurance perspective, the conventional loan seems like a much better deal.
The author praises the use of FHA mortgages, then later makes the following statements about private mortgage insurance:
“PMI should be avoided as it will usually cost the homeowner between 0.5% to 1% of the full mortgage amount….”
“…it is not great that so many are also paying for PMI as a result of less-than-optimal down payments…”
Such blanket negative statements about PMI concern me. In our example, and many examples where the borrower has a strong credit score and can make a 10% or more down payment, the numbers often favor conventional loans. FHA loans are often better when the borrower’s credit score is low or the borrower can only make a down payment of 10% or less.
The key lesson here is to consult a professional mortgage lender (I suggest that this guy for Georgia home buyers) to run the numbers for both FHA and conventional loans. Then choose the best option given your circumstances.
Now let’s change our buyer scenario. Both Jack and Diane want to make offers on a home, but this time they have 10% to put down. (Curious about a smaller down payment? Take a look at the prior scenario with a 3.5% down payment.) They still have the same qualifying credit scores of 680 for Jack and 795 for Diane.
With Jack’s 680 credit score, his monthly payment for a conventional loan (principal, interest, and mortgage insurance “MI”) would be $1,514.30. For a FHA loan, his payment would be $1,452.29. Given Jack’s credit score – even with the 10% down payment – FHA still delivers a better price, even though FHA loans have the draw backs of the up-front MI and the permanent monthly MI (assuming Congress does not change the law).
In this scenario with Jack’s 10% down payment, the mortgage insurance falls off after 11 years (even if Congress doesn’t act). Meaning, the FHA loan becomes even more attractive now and into the future.
With Diane’s 795 credit score, her monthly payment for a conventional loan would only be $1,391.24. Her FHA loan payment would be $1,452.29. (Note that it is the same as Jack’s payment, even though Diane’s credit score is over 100 points better.) In this case, Diane can now save money by using the conventional loan. The conventional loan has the best pricing from the beginning, and it provides the PMI cancellation benefits mentioned in the previous post.
With this example, one can definitely see how FHA loans do not have the same impact when it comes to the interest rate, mortgage insurance, and monthly payment versus conventional loans. Even with such a large gap between the credit scores (680 versus 795), the payment on the FHA loan is the same.
Ultimately, every client situation is unique. For some borrower circumstances (e.g., self-employed, buying a condo, high debt to income ratio, etc.), we may recommend one loan option because the buyer has a better chance to win approval, even if the payment winds up being slightly higher.
Do you know someone planning to buy a home in Georgia? If they have questions, connect them with me. I love helping people understand their mortgage options and helping them determine the best approach to financing a home purchase.
Now let’s take a look at conventional mortgage details. (Click here to review FHA loan details. And here is a link to the Home Ready program changes.)
In general, conventional loans are less forgiving of credit issues than are FHA loans. Conventional loans require longer wait times after derogatory credit events like foreclosure or bankruptcy. And the borrower’s credit score has a much greater impact on conventional loan pricing versus FHA loans. The lower one’s credit score, the higher the interest rate. In some cases, a credit score 100 points lower could cause the borrower’s interest rate to increase by almost one percentage point.
Ultimately, this makes conventional mortgages less attractive to borrowers with lower credit scores and more attractive to those with higher credit scores.
Conventional loans do not require up-front mortgage insurance, but private mortgage insurance (“PMI”) is required for down payments less than 20%. PMI rates vary based on the borrower’s credit score and down payment. For the same loan amount, the monthly PMI will be dramatically different for a 690 credit score borrower making a 5% down payment vs. a 780 credit score borrower making a 15% down payment. PMI is not permanent. It automatically terminates when the borrower’s loan balance reaches 78% of the original contract price or appraised value (whichever is lower). And, in certain circumstances, the borrower can request PMI cancellation prior to reaching the 78% threshold.
Borrowers can obtain a conventional loan with a minimum 3% down payment. This often only makes sense when the borrower’s credit score is 720 or higher. With a lower score, the PMI cost for a 3% down loan can get pretty expensive. We often recommend that conventional buyers make a 5% or more down payment to keep PMI costs lower.
Another advantage of conventional loans is the maximum loan amount. While FHA caps out at a purchase price of around $390,000 using the minimum down payment, conventional loans can go higher. How much higher? How about a $500,000 purchase price with a 3% down payment. That is about 25% higher than the FHA maximum.
In the next posts, we will compare some hypothetical home buyer scenarios to determine which loan is best – conventional or FHA. Do you know someone who wants to buy a Georgia home? Please refer them to me. We Dunwoody Mortgage professionals ask important questions to determine if we can help our clients make slight changes (down payment amount, paying down a credit card balance, etc.) that help them save money with a better interest rate and / or lower PMI premium. We work hard to deliver excellent service and pricing to our customers, and our consistently positive reviews show our clients are pleased with our work.
As recently reported in The Mortgage Blog, mortgage interest rates have dropped to their lowest level in over two years. The last time rates were consistently this low was just before the 2016 Presidential election. For people who purchased homes since then, it may make sense to refinance now. So how do you decide if a refinance is right for you?
I read one article from a major think tank stating you should refinance for a rate that is a specific amount lower than your current rate. I believe that is a bit simplistic and you should crunch numbers in more detail. I recommend comparing the financial benefits against the cost of refinancing – the total amount you can save each month versus the refinance cost.
With a rate / term refi, you will save by lowering your monthly interest payments and, possibly, by lowering or eliminating private mortgage insurance (PMI) payments. I recommend you focus on the dollar savings. A 0.5% interest rate change on a $100,000 loan will save you much less per month than the same interest rate change on a $400,000 mortgage. Eliminating or reducing PMI payments can provide significantly lower monthly payments. To eliminate PMI, you must must have 20% equity. Perhaps your home’s value has increased since you bought it. You can capture this higher value as equity in the new loan using a new appraisal value. If the appraisal shows you have greater equity, even if it’s less than 20%, you may see your PMI payment reduced, perhaps substantially.
How do I analyze the savings? I estimate a new monthly payment based on the lower interest rate and potential PMI changes and compare this rate versus their current payment. Then I divide the refi closing cost by the monthly savings to get a “break even” point. If the monthly savings break even on the closing costs in three years or less, I typically recommend that the client pursue the refinance. Why three years? It seems most people have a general idea of their plans for the next three years or so. Anything further than that becomes a little murkier. I’m currently working with a client who has a $335,000 loan. I estimate a refinance will save her $150 per month and will “break even” in about 22 months. That seems like a wise financial move to me.
Another option to consider is a cash out refinance. Is there a home project you want to do? Perhaps a kitchen or bathroom renovation? I have clients using their home equity and lower interest rates to take cash out for a project, and still have the same payment (or even a better payment) than they have now.
Do you know someone who bought a Georgia home in 2017 or 2018? Ask them what they would do with an extra $100 per month. Then refer them to me. I’ll run the numbers to determine whether refinancing is a wise move.
Joe Tyrrell, an executive with mortgage software company Ellie Mae, recently stated, “People still have the misunderstanding that they need a FICO score above 720 and more cash for a down payment, so they don’t apply for loans because they assume they’ll be denied.” These would be borrowers are self-selecting themselves out of the home buying market based on false assumptions. So let’s clear up some mortgage myths.
Firstly, borrowers do not a need “great” credit score to win mortgage approval. Conventional loan guidelines allow credit scores down to 620. FHA loan guidelines allow credit scores down to 580. And now non-traditional loans exist that can approve borrowers with scores down to 500 and derogatory credit events (e.g., bankruptcy or foreclosure) in the last two years. Note that the lower one’s credit score, the higher the interest rate the borrower will face. But FHA interest rates for lower credit score borrowers are not ridiculously high relative to rates for higher credit score home buyers.
Secondly, winning loan approval does not require home buyers to break their proverbial piggy bank and make a large down payment. Home buyers can obtain FHA loans with a minimum 3.5% down payment, and they can win conventional loan approval with a 3% down payment. And if the home buyer qualifies, he / she could obtain a low-interest Home Ready or Home Possible loan with a 3% down payment. Qualifying military veterans can secure 0% down payment VA loans. Buyers in rural areas can receive 0% down USDA loans in approved counties.
What may confuse potential home buyers about down payments is the fact that conventional loans require a 20% down payment to avoid mortgage insurance. But as long as the buyer can win loan approval with the added monthly mortgage insurance expense, the buyer can get their mortgage with a down payment of only 3%. This 20% down payment myth requirement is widely held. Even some financial journalists hold this incorrect notion, as shown by this statement in a recent Wall Street Journal article, “While conventional mortgages can require buyers to put down as much as 20% of the purchase price up front, FHA buyers can pay as little as 3.5%.” Regardless of what some journalists write, I can help home buyers win conventional loan approval with a down payment as low as 3%!!
Home buyers should remember that they will have to pay closing costs and prepaid escrow in addition to the down payment. So buyers should plan to invest more cash than just the down payment at closing. But buyers have options to help with their cash to close needs. We will explore those options in the next post.
For now, do you have a friend or co-worker who wants to buy a house but is concerned about the down payment or credit score requirements? Connect them with me and I will help them obtain the best mortgage for their financial situation and home needs.
Not that long ago, conventional loan guidelines began allowing borrowers to have a back debt to income ratio as high as 50%. The “back” ratio is the new housing payment + all other debt / monthly income. The limit was 45%, so the increase allowed borrowers to carry a slightly higher debt threshold. This is closer to what FHA allows (up to 55%).
Private Mortgage Insurance companies observed the change, and then began making changes of their own. As of this post, all but one of the major PMI companies have changed their guidelines to reflect the following requirement. For borrowers with a debt to income ratio at 45-50%, their credit score must be over 700. For all other borrowers with a debt to income ratio under 45 %, credit scores can go as low as 620. While this change won’t impact a majority of home buyers, it is significant. Basically, if a buyer has a higher debt to income ratio and a credit score under 700, then they must use an FHA loan to buy a home (or VA if they qualify for a VA loan). For now, conventional loans may not be an option.
Guidelines change frequently, and this could be temporary to see how conventional loans with a debt to income ratio of 45-50% perform. Hopefully that will be the case, but for now, it is in place.
Planning on using a conventional loan to purchase a home, but have a high debt to income ratio? If you are buying a home in Georgia, let’s talk sooner rather than later and make sure no changes need to be made to current plans.
Clay Jeffreys is a Mortgage Consultant with Dunwoody Mortgage Services and a writer for “the Mortgage Blog.” If you would like to be a guest writer for "the Mortgage Blog" please contact Clay for details.
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