It’s important to understand these two costs before you sign off on that mortgage.
If you’ve reached the starting line of the home-buying process with little debt and a stellar credit score, you might have a big head start if you qualify to skip the dreaded 20% down payment. But while a lower down payment on a home for sale in Sioux Falls, SD, or a craftsman home for sale in Athens, GA, might appear to be an easy way to save both time and money upfront, you won’t get off entirely scot-free.
In fact, you’ll have to compensate for this decision through higher financing costs and the addition of private mortgage insurance (PMI). Plus, when you factor in the proposition of buying mortgage points to lower your interest rate or cover origination costs, your financial picture might look a lot different than you had hoped.
So before you commit to a mortgage, make sure you fully understand the impact of these two tricky concepts.
What is PMI? Well, that low down payment could cost you
To protect the mortgage company should you default on your loan, loans underwritten to Fannie Mae and Freddie Mac standards require you to hold PMI until you reach a designated time or until your loan balance reaches 78% to 80%. So while you, the homeowner, pay the premiums, the lender would benefit if you were to default on your loan.
The cost of this type of insurance varies based on the size of your down payment and your credit score, but can range anywhere from 0.03% to 1.5% of the total loan amount. For example, assuming a 1% PMI rate on a $200,000 loan with no down payment, you’d be required to fork over $167 every month.
In years past, private mortgage insurance has been tax-deductible for those below certain income thresholds, lessening the impact of this added expense. It’s possible the current tax deduction on mortgage insurance payments will be extended, but it shouldn’t be taken for granted.
Once you’ve managed to reach a loan balance of 80%, private mortgage insurance doesn’t simply disappear. To have it removed, you must request the cancellation in writing and be in good standing regarding payment history. In addition, you may have to pay for an appraisal to prove the value of the home or submit proof that you don’t have any liens on the home.
However, once you’ve reached 78% of the loan amount, as long as your payments are up to date, your lender must automatically cancel your PMI. (For more information, check out the cancellation guidelines from the Consumer Financial Protection Bureau.)
Mortgage points: The pursuit of a lower interest rate
Just in case things aren’t complicated enough, there’s another hidden mortgage cost that can further change the structure of your loan: mortgage points. There are two types: discount points and origination points. Both are equal in value — 1 point equates to 1% of the loan amount.
Discount points are essentially a way of prepaying the interest on your loan. As the borrower, you have the option of paying these additional points to lower your monthly payment.
If you plan on staying in your home for several years, this could be a great way to lower your monthly rate. However, it’s important to calculate when you will break even and begin to recoup the cost of forking over thousands upfront. If it’s longer than you plan on staying in the home, it might not be the best way to go.
In addition, it’s important to consider whether your money would be better spent on a larger down payment to reduce your monthly PMI payment.
Origination points, also referred to as loan origination fees, are used to pay the administrative costs for acquiring a loan. The number of points assessed can be impacted by your credit score but usually fall around 1 point or 1%. Depending on the lender, these fees can be negotiated.
While discount points are tax-deductible because they cover the interest on your loan, origination points or fees are deductible only if they were used to obtain the mortgage and not to cover other closing costs.
Bottom line: A down payment isn’t the only thing to consider
While you may have scored a loan with no down payment requirement and a great interest rate, you still have plenty of mortgage costs to consider. The most important component of buying a home is to make sure you understand all facets of this financial obligation before signing on the dotted line.