The appeal for a low down payment option with an FHA loan is attractive to many first-time homebuyers but there are trade-offs. A conventional loan usually requires 10% to 20% down minimum depending on the terms but an FHA loan, which stands for Federal Housing Administration loan, allows for a 3.5% down payment and in combination with other loan programs may even offer less than that. But, there is a catch.
Private mortgage insurance is naturally tacked on to an FHA loan. This can cost home buyers hundreds of dollars each month, which typically ranges from .55% to 2.25% of the original loan amount each year. This means that for a $200,000 loan, private mortgage insurance or PMI can be between $1100 and $4500 each year or up to $375 per month added to your monthly mortgage payment, not including property taxes.
So what is PMI?
Private mortgage insurance protects the lender from losing money if the borrower defaults on their home loan. Most lenders require private mortgage insurance for conventional loans when the buyer makes a down payment of less than 20% but all FHA loans have this type of mortgage insurance regardless of the down payment amount.
This ensures that if the borrower defaults on the home loan, the value of the property will not exceed what it costs to resell the property, meaning the lender is giving themselves some insurance in case they need to sell the property for less than what the borrower owes.
So how can homebuyers avoid private mortgage insurance?
Basically, borrowers cannot avoid this if they choose an FHA loan. However, they can get rid of PMI eventually if homes are appreciating. Once the property reaches 8080/20 loan to value ratio, homeowners can either petition to have the PMI removed or apply for a new home loan, basically refinance. This means that they must oh less than 80% of what the home is worth before the private mortgage insurance can be removed.
There are alternative loans, however. Many banks offer affordable load solutions, down payment assistance programs, and USDA home loans, which may offer 100% financing, but every bank, mortgage officer, and lender is different so it's important to speak with a mortgage officer that has access to all types of home loans, not just the one from a particular bank. They can be creative in their lending and it really determines the best loan for you.