Myth #1 — You need a 20% down payment

“I can’t afford to buy a home.” 

“The interest rates are too high.”

“We’re entering a recession.”

There may be some truth to these claims, or maybe these ideas have been percolating our culture long enough to integrate into our belief system. Regardless of where they came from or how long they have been here, these are some home-buying myths that I hear and my plan is to go deep today and pull you out of this cloud of deception.

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Myth #1 -You need to make a 20% down payment

One of the most persistent myths about buying a home in Seattle is that of the 20% down payment.

this doesn’t mean you have to come up with the entire 20%. Instead, lenders use a tool known as mortgage insurance to accomplish risk mitigation when they loan more than 80% of the cost of the home.

Let’s explore the concept of mortgage insurance.

There is a notion in lending called, protective equity. This is the difference between the value of the real estate and the loan amount. You might think of it as “skin in the game;” the investment that keeps a borrower from walking away. In a home loan, the down payment serves as the protective equity.

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 in the case of a defaulting borrower. 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. Mortgage lenders hate that. 

A 20% down payment is the accepted amount that 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 likely approve the loan but will require additional protection. That’s where mortgage insurance comes in.

You may have heard the term “PMI,” which stands for Private Mortgage Insurance. This means that a private insurance company protects the lender. (I should also note that there are government-insured FHA loans, which are insured by HUD, so their insurance can’t be called “private.” The correct term for FHA insurance is “MI” or “MIP,” for Mortgage Insurance Premium.)

Whether private or not, all mortgage insurance works in the same way. If a lender has to foreclose because of the borrower’s default, the property 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.

Mortgage Insurance can be an alternative to the large down payment that may be out of reach for many borrowers, especially first-time home buyers. It mitigates the lender’s risk and allows them to extend a loan to buyers with smaller down payments.

The majority of homes purchased in Seattle involve some form of mortgage insurance.

The cost of PMI depends primarily on two things: the loan-to-value ratio or the LTV, which is the loan amount as a percentage of the home’s value, and the borrower’s credit score. These two factors are heavily weighted to evaluate the lender’s risk.

There is a lot of simplified and outdated financial advice on the internet today. This includes claims that PMI may be financially irresponsible. I’m determined to show you that this is not the case. No one wants to overpay for anything. But here is the real trap that people fall into by not considering PMI.

PMI lets you buy a home sooner, with less money down. There are many benefits of home ownership, and the biggest benefit of them all is growing home equity. 

It can also help you save tens of thousands of dollars on buying the same home. Let’s say you find a home for $700,000. You can only afford a 5% down payment today. That means you might pay $320 a month in PMI. If you get a 30-year fixed rate loan at 5% interest your monthly P&I payment would be $3,569.86.

Now, if you didn’t want to pay PMI, you could wait until you can afford to make a 20% down payment. That’s an extra $105,000 down, based upon the same price. Of course, if that takes you another three years, and somehow that home you loved comes back on the market, it is probably going to cost more. Over the very long term, home prices go up by an average of 5% per year. Sometimes more in Seattle. So, that same house would now probably cost at least $105,000 more. So, you’d need close to a $165,000 down payment to avoid PMI.

And, even after all that, the $320 PMI is still making you feel uncomfortable, remember that the insurance is temporary. Whereas your interest rate may be with you for 30 years, you will only have to pay the PMI until your loan balance drops beneath that 80% loan-to-value mark. And if the housing market is strong, you may also have appreciation on your side. You may be able to request that it be removed from your loan in just three years. Lenders will remove it voluntarily once you get down to around 78%.

PMI has a bad reputation, but depending on the factors listed above, it can make mathematical sense. Asking for a loan with PMI has the potential to save you hundreds of thousands of dollars, on buying the same home now, rather than waiting years down the line.

*PMI rates can vary between companies and are adjusted based on home value appreciation expectations. According to West Seattle Mortgage, buyers in Seattle, with a 5% down payment can expect to pay a premium of approximately 0.78% times the annual loan amount, $92.67 monthly for a $150,000 purchase price. However, the PMI premium would drop to 0.52% times the annual amount, $58.50 monthly if a 10% down payment was made.