Risks of Less than 20 Percent Down

When buying a home, conventional wisdom holds that you should make a 20% down payment. But today, more than half of homebuyers put less than 20% down. Many home loans require only 3% to 5%, and the median home loan is just 14%.

You may be able to put less than 20% down on a home, but should you? Read on to learn about the potential downsides of making a smaller home down payment.

What is PMI?

If you buy a home with a conventional loan and make a down payment of less than 20%, you’ll typically need to buy private mortgage insurance (PMI). This coverage isn’t designed to protect you. It protects your mortgage lender if you stop making mortgage payments.

You pay for PMI monthly. The cost depends on factors like the size of your loan, your down payment, and your credit score. But PMI costs usually range from 0.5% to 2.25% of your mortgage loan amount each year. So if you get a $750,000 mortgage and your PMI fee is 1.5%, you’d pay $11,250 a year for PMI, or $937 a month. The good news: PMI is adjusted annually based on your remaining loan balance, so your PMI fee will go down as you pay down your loan.

At closing, you’ll typically pay an upfront insurance premium for PMI. After that, you’ll make monthly payments, which are added to your monthly mortgage payment, along with your mortgage principal, your homeowners insurance premiums, interest, and taxes. You may have the option to pay PMI yearly, but if you sell your home mid-year, you won’t get back any of the money you paid for PMI. In some cases, you can buy an entire PMI policy at closing, so you won’t make monthly or yearly payments. Your loan officer can advise you of options.

You can usually request that your PMI policy be dropped when the outstanding balance of your loan reaches 78% of the original loan amount. In some cases, the lender may request that it be dropped when you reach 80% of the loan amount. And if you make improvements on your home or your home’s value otherwise rises, you may be able to get your home reappraised and cancel your PMI earlier than expected. If you have an FHA loan (and you bought your home after June 3, 2013), you’ll need to keep your PMI policy until you pay off your mortgage.

Risks of putting less than 20% down?

While making a lower down payment will help you buy a home sooner, putting less than 20% down comes with risks.

• Your monthly mortgage payment will be higher. Generally, the less you put down, the higher your monthly mortgage will be. Also, you’ll need to have PMI, so that cost will likely be added to your monthly payment.
• You may pay a higher interest rate. Some lenders charge a higher rate for homebuyers who make a smaller down payment.
• You’ll have less equity in your home to start. If you put less than 20% down and then decide to sell it in a few years, you may not have enough equity in your home to cover the costs of selling it.
• You may be less likely to get the home you want. When you’re buying a home, especially in a competitive market, offering less than 20% down could make you less attractive to the seller compared to buyers who are offering 20% down.

PMI vs. MPI

Private mortgage insurance (PMI) is insurance that you buy to protect your lender if you default on your mortgage loan. Mortgage protection insurance (MPI) is similar but not the same. It’s mortgage insurance that you buy to protect yourself in case you become disabled or lose your job and can no longer make mortgage payments. It also pays off your mortgage if you die. PMI may be required, while MPI is optional coverage.

Is it better to put 20% down or pay PMI?

There’s no right answer. It really depends on your situation.

If you can comfortably afford to put 20% down, doing so is usually a smart move. If making a 20% down payment will wipe out your savings, though, you may want to make a smaller down payment. That way, you’ll still have a financial cushion after purchasing your home. If you have good credit, you’ll likely get a better deal on PMI. And once you’ve built some equity, you can cancel your PMI and free yourself from those monthly payments.

If you don’t have the 20% down payment now and you want to avoid paying PMI, you have some options. You could continue saving until you have a 20% down payment. However, you may find that you’re aiming at a moving target. As home prices rise, so will the down payment amount you’ll need.

You could apply for down payment assistance. Government agencies and other organizations offer such programs, especially for first-time homebuyers. The California Housing Finance Agency offers their MyHome Assistance Program, for example. If you’re a veteran, service member, or surviving spouse, you may qualify for a VA Home Loan that doesn’t require a PMI policy.

There are also programs that offer grants that don’t need to be repaid like the National Homebuyers Fund and the PenFed Foundation’s Military Heroes Program.

Another option is taking out two mortgage loans. You could take out a loan for 80% of the home’s value, and then a second mortgage to cover the rest, minus your small down payment, called a piggyback loan. That allows you to pay less out of pocket without needing PMI.