One of the most persistent — and damaging — myths about buying a home in Seattle, WA is that of “the normal 20% down payment.” It is true that lenders need to limit their risk when a loan is for more than 80% of the home’s value, and that mortgage insurance is the tool they use to accomplish this.
Let’s visit the world of mortgage insurance and learn what it is — and what it is not.
When lenders approve a loan, they are always thinking about risk. The questions at the top of their mind are these:
- Will the borrower repay the loan as agreed?
- What might happen if they don’t make their payments, and we have to foreclose? Would we take a loss?
There is concept in lending called “protective equity.” You might think of it as “skin in the game,” the investment that keeps a borrower from walking away; but it is also the amount of money (equity) above the loan that will keep the lender from losing money if things were to go bad.
When a lender approves and funds a loan, it looks to the property as security for the loan. The security is typically in the form of a “deed of trust.” This is the legal instrument that allows the lender to foreclose and force the sale of the property to get its money back from a defaulting borrower. In this respect, it is quite similar to a bank’s holding a car’s title (the “pink slip”) until their loan has been paid in full. If the borrower stops making the payments on the car, the lender can repossess the car and sell it to get the loan paid off.
If the car sells for a high enough price, the lender gets its money back. If it doesn’t — and this is called a “deficiency” in legal terms — they’ll have to pursue the borrower for the shortfall. Sometimes they can get it, most times they can’t, so they take the loss.
The principle is similar in mortgages. The lender is able to pursue the legal process of foreclosure to get their money back when the borrower stops paying. If the price they can get for the house at an auction doesn’t cover their outstanding loan balance plus past due payments and other expenses, they’ll take a loss. Seattle Mortgage Lenders hate that.
A 20% down payments reassures the bank that if they had to foreclose on the property, the cash put up by the buyer would be enough to protect them. If the buyer wants to put less money down—let’s say 5% — they’ll still approve the loan, but only with some additional protection. That’s where mortgage insurance comes in.
You may have seen the term, “PMI,” which stands for Private Mortgage Insurance. This means that a private company (not a government agency) provides the protection to the lender. We should also note that the term PMI is not accurate for all types of loans with small down payments. There are government-insured FHA loans, which require down payments as low as 3,5%. These loans are insured by the Department of Housing and Urban Development (HUD), so their insurance can’t properly be called “private.” The correct term for FHA insurance is “MI” or “MIP,” for Mortgage Insurance Premium.
All mortgage insurance works in the same way. If a lender has to foreclose because of the borrower’s default, the property ultimately will be sold at auction, called a Trustee’s Sale. If the sale does not bring enough money to pay off the delinquent loan plus all the associated fees, costs and expenses, the mortgage insurance company steps in to cover the lender’s loss.
While some people think of a lender’s requirement that a borrower pay for mortgage insurance when their down payment is less than 20% as some sort of punishment with no benefit for the borrower, there is a better way to view it. Mortgage insurance is simply an alternative to the large down payment that may be out of reach for many borrowers. It allows the lender to extend a loan to buyers with smaller down payments because mortgage insurance limits their risk.
The median down payment nationwide in 2018 was just $19,900. With the median purchase price of $255,000, a typical down payment was less than 8% of the purchase price. This means that the majority of home purchases involve some form of mortgage insurance.
The cost of PMI depends primarily on two things: the loan to value ratio (the loan amount as a percentage of the home’s value) and the borrower’s credit score. Both factors affect the lender’s risk.
PMI rates vary somewhat between companies and adjust based on home value appreciation expectations, but you can currently expect to see a rate of about .30% for a 90% loan and a credit score of 760 or higher. The same loan for a borrower with a 620 score (the minimum acceptable score for a conventional loan) will carry a premium of 1.1%. For a $500,000 home, this would mean a monthly premium between $113 and $413, respectively.
- Sammamish Mortgage currently has a source for reduced PMI which would bring the 760 credit score example above down to a .19 PMI premium which equals $71 per month.
On a conventional loan a borrower can remove PMI when they have enough equity. While it’s a common assumption that PMI is always removed when you reach 80% LTV there is more to it than that. While a lender may tell you upfront that they will remove PMI once you reach 80%, their policies can change and will change if the house market takes a downturn. Therefor it is important to know when a lender is required to remove PMI. Our PMI webpage (PMI Removal) has specific government guidelines outline when a lender is required to remove PMI.
FHA loans also carry mortgage insurance, but it works in a slightly different way. Today, there is an initial up-front premium of 1.75%. It is added to the base loan amount, so the buyer doesn’t have to pay out of pocket. There is also a monthly charge, which is typically .85% for a loan with 3.5% down. Loans over $625,500 have a slightly higher premium — 1.05% for a loan with the smallest down payment.
Unlike PMI for conventional loans, FHA insurance for the minimum down payment remains in place for the entire term of the loan. A borrower can remove it only by refinancing into a conventional loan.
Why would someone choose an FHA loan with its more expensive mortgage insurance if they have the ability to make a 5% down payment? The answer is that FHA can be more economical for a borrower with a lower credit score, because the premium is the same regardless of score. While a buyer with a 680 score will be able to qualify for a conventional loan, they’ll pay a higher rate for both their mortgage and the mortgage insurance premium. The rate for monthly PMI will be approximately 1.1% for a buyer with that score, and the rate they’ll get on their mortgage will be about .25% higher than it would be if they were sporting a score of 740 or higher. The insurance premium for an FHA loan will be the same for any credit score — and the adjustments applied to the interest rate will be less severe than for conventional loans.
The message you should take away is that buying a home in Seattle, WA does not require the large down payment that many people think it does. There are conventional loan programs available today requiring down payments as low as 3%, so becoming a homeowner might just be closer than you think.