Mortgage payments include more than principal, interest, homeowner’s insurance and taxes. You also have to worry about private mortgage insurance (PMI) if you put down less than 20%.
PMI is required on all mortgages with less than a 20% down payment, and this type of insurance protects lenders in case a borrower defaults. As the mortgage borrower, you're responsible for paying private mortgage insurance. This expense is a blessing and a curse.
On one hand, private mortgage insurance lets you purchase a home with little down, but on the other hand, it also increases your mortgage cost. Fortunately, there are options if you want to avoid private mortgage insurance.
1. Wait until you have a 20% down payment
Coming up with a 20% down payment is easier said than done. But if you want to avoid private mortgage insurance, this is the number one way to do so. The upside to avoiding private mortgage insurance is that you don't have to necessarily use your own funds. If you apply for a conventional mortgage loan, the bank will allow a family member to gift your 20% down payment.
2. Use retirement funds for a down payment
Another option is to borrow money from your retirement account, but only as a last resort since this can be an expensive move. Understand that taking money from a retirement account minimizes your savings potential, but if you’re young and have time to recoup, it’s an option worth considering. Still, you need to understand the rules for withdrawing money from a retirement account to cover a down payment.
With a Roth IRA, you can withdraw your contributions without penalty or tax, which is the most cost-effective alternative, if you have one of these accounts. If you have a traditional IRA, you can withdraw up to $10,000 for a first home purchase without paying a penalty, but you will pay income tax on the amount.
You can also take money from a 401(k) for your down payment, but you will pay a 10% penalty and income tax on the amount. Another option is to take a 401(k) loan. You can borrow up to $50,000 or half the value of your account. You'll pay interest on the loan, but you avoid taxes and penalties with a loan. The only problem with borrowing from a 401(k) is that you'll repay this loan through payroll deductions, and your mortgage lender includes this monthly payment when underwriting the mortgage. To put it plainly, borrowing from your 401(k) may reduce the amount you qualify for and limit purchasing power.
3. Get a piggyback mortgage
Piggyback mortgages pretty much died after the housing bust, but some lenders are bringing these loans back. This is another option to avoid private mortgage insurance, but only if you have a bigger down payment. With a piggyback mortgage, you receive a first mortgage for 80% of the sale price, a second mortgage for 10% of the sale price, and then you give the bank a 10% down payment.
4. Choose a conventional mortgage over an FHA
No matter how hard you try, sometimes you can't avoid mortgage insurance. But there is something you can do to limit how long you pay PMI.
There is a difference between mortgage insurance with a conventional loan and an FHA loan. If you apply for a conventional loan with PMI, the bank will waive mortgage insurance once you have 22% equity. But with an FHA loan, you pay mortgage insurance for the life of the loan regardless of how much you owe. For that matter, an FHA loan can be more expensive in the long run. If you get an FHA loan, one option is to refinance from an FHA to a conventional mortgage once your loan-to-value ratio hits 78%.
5. Community mortgage programs
A big bank isn’t your only option for a mortgage loan. Many larger banks sell their mortgages to Fannie Mae or Freddie Mac—two of the largest mortgage buyers. Both agencies require PMI when a borrower puts down less than 20%. But if you get a mortgage through a community bank that doesn't sell its mortgages, you can find special financing options. For example, a community bank may have a mortgage program where you put down 0% in exchange for a higher mortgage rate. You’ll pay a slightly higher monthly payment, but the upside is that you can purchase without wiping out your savings account.