Dennis Smith: Author, Chef, Financier; Co-Owner/Broker at Stratis Financial, Huntington Beach; MLO Student
Question of the Week
Why is mortgage insurance a good thing?
Last week in the Weekly Rate & Mortgage Update we discussed if home buyers should wait until they have 20% for down payment before purchasing (you can read the WR&MU, and I encourage you to, but the short answer is “No.”). The primary reason many clients give us for wanting to wait until they have 20% down is to avoid paying mortgage insurance.
To which I always counter, mortgage insurance is a good a thing and not something you may want to avoid.
Which leads to the question of the week, why is mortgage insurance a good thing?
The Quick and Simple Answer
The quick and simple answer is because it can enable you to purchase your home a lot faster.
As discussed last week, the number one cause of delay for families purchasing homes, according to a California Association of Realtors survey, is waiting to save for down payment and closing costs. A significant number of these delayed purchases are due to wanting to have 20% down to avoid mortgage insurance. But is the delay worth it? We covered the potential cost and missed opportunity last week of waiting, what is the cost of not waiting and buying when you can?
Before we begin the conversation of why mortgage insurance is good, let’s examine what mortgage insurance is. For those new to the conversation, mortgage insurance is not insurance that pays off the loan if you pass away or become disabled—there are life insurance and/or disability insurance policies you can get to cover the mortgage to protect your home and family should something happen.
The Purpose of Mortgage Insurance
The purpose of mortgage insurance is not to insure you, but to insure your lender should you default and go into foreclosure. Between the missed payments, legal fees, professional fees, loss of value due to foreclosure sale and other costs, a lender will average about 35% of the value of the property. Because of this if you have less than 20% down the lender will require mortgage insurance that covers the difference between your initial down payment and 35% of the purchase price.
For example, if you are purchasing a home with 5% down the lender will require 30% coverage from a mortgage insurance company, if you put 10% down coverage of 25% will be required, and if you put 15% down coverage will be 20%.
Even with this protection, should a home go into foreclosure there will likely be losses to the lender. Consider the process and losses. It typically takes about eight to nine months for a home in California to be foreclosed on after the first missed payment. Once you miss a payment by more than 30 days, i.e. you do not make your March 1st payment by April 1st, you are in default of the note. To cure the default, you need to make all payments due plus late payments. So, if you miss the March payment you have until April 30th to make the March payment plus the late fee and the April payment plus the late fee, if applicable.
If you are unable to cure the default at some point the lender must make a foreclosure avoidance assessment to discuss with you the circumstances that led to your default and if there is any way to avoid foreclosure. If there is no agreement between you and the lender to continue with the mortgage, i.e. a modification, the lender can then record a Notice of Default (NOD) with the county recorder in which the property is located no sooner than 30 days after the initial contact for the assessment. After 90 days or more have passed since the filing of the NOD the lender can then record a Notice of Sale informing you that the lender intends to sell the property at auction in 21 days or more. At auction, the lender will sell to the highest bidder who must have cash or a cashier’s check, it is very likely that the first bid will be placed by the lender for the outstanding balance due plus foreclosure costs. At the fastest a foreclosure can occur within about 200 days of the first missed payment, however they generally take about 60 to 90 days longer—or depending on circumstances can take much, much longer.
If you purchased a home for 5% down and a $400,000 mortgage with mortgage insurance and are foreclosed on the lender will be reimbursed for losses up to 30% of the loan amount, $120,000, by the mortgage insurance company.
Different Methods of Paying for Mortgage Insurance
There are different methods of paying for mortgage insurance. You can pay monthly, a full premium upfront, or fund a “no PMI” mortgage that is a loan that is self-insured by the lender due to a higher interest rate on the mortgage. Of the different types of payments, the most popular is the monthly payment, primarily for two reasons. First and foremost, it is able to be removed from the mortgage for most transactions after you have made 24 consecutive on-time payments and can show evidence (lender approved appraiser’s valuation) that you have at least 20% equity in the property you can request the PMI and its payments be removed from you loan—caution, do not just engage an appraiser, contact your lender with your request and get a list of approved appraisal management companies to contact for an appraisal. When your loan balance become 78% of the original purchase price, or appraised value, of the property when the loan funded the lender must drop the mortgage insurance without a new appraisal. The second reason payments are popular is that for the past several years mortgage insurance has been deductible for federal income taxes depending on your income.
What is Your Benefit?
That is the purpose of the mortgage insurance, what is your benefit.
That you can purchase a home with as little as 3% down, or 5%, 10%… In California, and most real estate markets, being able to purchase a home without having to save 20% of the payment is tremendous benefit. Doing the math, for a $500,000 home you can purchase a home with only 3% down payment (higher sales prices qualify for 3.5% down payments using FHA, or no down payment if you are an eligible Veteran).
What is the advantage to purchasing a home with less than 20% down? Not having to wait to save the 20% down payment and missing the opportunity of home ownership for perhaps several years—or ever. Consider how long it will take you to save a 20% down payment on your current income, even if you are able to eliminate all your debts—which delays your ability to save. Two years? Three? Five? Ten? During this period will housing prices be stagnant, or increasing faster than your income increases? As you try to save the amount you need to save will continue to increase creating a longer delay in your ability to purchase.
If you know you are going to receive a large financial windfall in the very near term, which I define as less than six months, from a lawsuit settlement, sale of a major asset such as a company, boat or other property, or an inheritance, you may be able to shorten your ability to gather the 20% down. But for most families this is not the case and they should be open and favorable to purchasing a home using a lower down payment and mortgage insurance.
The Monthly Cost
The monthly cost of mortgage insurance is a lot less than most potential homebuyers think it will be, and MI is cheaper today than for non-government loans than in the past (MI for government loans is higher today than it was several years ago).
For a $400,000 here are the monthly costs for a borrower with 740 credit score in California purchasing a home with a 30 year fixed rate mortgage for different down payment amounts:
- 5% down has a monthly PMI payment of $177
- 10% down has a monthly PMI payment of $127
- 15% down has a monthly PMI payment of $67
If this loan has a 4.125% interest rate having a monthly payment of $1939, the 10% PMI payments effectively add one-half of one percent (0.50%) to the payment rate, lifting it effectively to 4.625%.
Consider purchasing a $445,000 house. To purchase with 20% down you will need a down payment of $89,000 and will have a payment, at 4.125%, of $1725 per month.
Purchase the same home with 10% down and you need $44,500 for down payment, easy math tells us you need $44,500 less. The monthly payment including mortgage insurance will be $2068, or $343 more per month. You are spending $343 more per month as long as you have the mortgage insurance, but saving $44,500 in funds needed to close.
Let’s assume the scenario above is a brand-new home and there are two that are identical at the same price next door to each other. James and Monica purchase one of the homes with the 20% down scenario and Jeffrey and Maria purchase next door with the 10% down scenario and they close on the same day. Every month on the they meet for cocktails on one of their porches, and before the mixing begins James and Monica put the $343 savings they have from not purchasing with 10% into a safe. The couples will have to have 129 evening cocktail gatherings before James and Monica have save the $44,500 in cash that Jeffrey and Maria did not put into the down payment for their home. That’s over ten years, but which time statistics show one of the homes will likely be sold due to job transfer, purchasing a bigger home or divorce.
The Obvious Drawback
The obvious drawback to the additional payment is the ability to qualify, with a higher monthly payment you will qualify for a lower loan amount and purchase price. Taking a look at this using the above scenario of an additional $343 added to your payment putting 10% down instead of 20% down and assuming that based on other debt obligations our borrower can qualify with 32% of their gross income can support the monthly loan, or monthly loan and PMI payment.
- For the 20% down scenario with a cost for the loan payment of $1725 income of about $5400 per month will be needed to qualify.
- For the 10% down scenario with the cost of the loan payment plus the PMI payment of $2068 income of about $6460 will be needed to qualify, about 20% more income for the same property.
That said, what is more likely for the average family, that a family making $5400 per month can save $89,000 at the same rate that a family making $6460 can save $44,500 or vice-versa?
Not waiting to save 20% down and using PMI to purchase a home may reduce the amount of home and mortgage you may qualify for, but it can greatly reduce the amount of time it will take for you to purchase your new home.
The best time to contact me about your ability to qualify for purchasing a new home is as soon as you decide you would like to purchase a new home. The sooner we discuss your financial situation the sooner we can work on a plan to homeownership that encompasses your available funds, if any, your income, debts, credit rating and what will need to happen, if anything, so you are able to purchase your new home. Perhaps it is a savings plan, or a debt reduction plan, or a credit rehabilitation plan, whatever may be holding you back from purchasing a new home the sooner we discuss your options the sooner you will be able to purchase your new home. Call me and let’s set up an appointment!
Ten years ago, I started working out of the house on most Fridays. My routine at home is to write some, most, or all of the Weekly Rate & Market Update and try to schedule some meetings for prospecting and networking, and of course communicate with the office and clients. Today as I sat working I heard and saw a large SCE truck in our alley and a few guys went up in a cherry picker to do whatever they do on the pole across from our home. As I was typing “The quick and simple answer…” I heard a loud noise and the house shook. “Oh, ‘goodness’,” I thought, did they hit the house? I looked up and saw the cherry picker halfway down and still in the alley. Which led to my going outside to see what the heck happened.
In lowering their bucket, they came down on a communication line and pulled the facia board the line was attached to off the house. Yippee! One of the workers went up on the roof and nailed it somewhat back into place and we completed a report and I received information about making a claim.
You can imagine my excitement in knowing my future will get to include interacting with a major utility company and tradesmen to get the repair completed and paid for by SCE. I hope you are not too jealous of this wonderful opportunity I have and you, likely do not.
Have a great week,
Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog
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