When a borrower puts down less than 20 percent on the purchase of a home, the borrower typically must have Private Mortgage Insurance (PMI). PMI pays the lender if the borrower becomes unable to pay loan.
In recent years, borrowers have been avoiding PMI when putting less than 20 percent down on a conforming loan, (a loan amount of $417,000 or less). The option lenders provide to borrowers as an alternative to PMI is a combination of a first and second mortgage. The second mortgage is often in the form of a line of credit tied to Prime, (the rate of interest banks offer to favored customers). The first/second option is favorable for eligible borrowers because Prime stays very low, with the interest rate currently at 3.25 percent.
If the borrower makes a down payment of less than 5%, lenders can offer a Federal Housing Administration (FHA) loan. FHA loans are insured by the federal government and provide mortgage lenders with ample insurance when borrowers default on their loans. FHA loans are currently most popular with first-time home buyers.
If PMI is used, monthly mortgage insurance is the alternative. The borrower pays a monthly fee until the loan is paid up to 75-80 percent.
Concerns to keep in mind are the potential for Prime to increase in the future, second mortgages only becoming available to borrowers with 10 percent or more down, and a raise in FHA mortgage insurance. It is worth reconsidering PMI as a practical alternative as these aspects change, specifically Lender Paid Mortgage Insurance (LPMI). LPMI provides the option of a fee paid at the beginning of the loan or paying a higher interest rate. The lender pays for the mortgage insurance in exchange for the specifications of the LPMI.
If a buyer chooses a first/second mortgage, the buyer usually secures a line of credit tied to Prime. The Prime rate is subject to change on a monthly basis. This option is currently only available when the borrower has 10 percent down. There are fixed rate alternatives for second mortgages but the rates are typically much higher than the first mortgage.
It is uncertain how high Prime may increase. Monthly mortgage insurance provides the borrower with the potential benefit of losing the monthly cost after the loan-to-value reaches 78 percent, but first an appraisal must be done by the lender. It is up to the borrower to facilitate the appraisal process.
The monthly mortgage insurance premiums for most FHA loans have increased to 1.35 percent, making the FHA monthly premium very expensive.
LPMI results in a slightly higher interest rate because the lender is paying the mortgage insurance out of the profit on the loan, but it also results in significant monthly savings for the borrower. LPMI could be a favorable solution for many borrowers, but it is crucial that borrowers evaluate their own unique circumstances when considering the structure of their loan.