There’s no shortage of options when it comes to financing your next personal home purchase. The list of available programs includes FHA, VA, USDA, and a myriad of other “low-down-payment” loan programs. This category of loans is known as “government insured,” meaning that the lender can file an insurance claim through the appropriate government agency, (FHA, VA, etc), if the borrower defaults on the mortgage.
In a nutshell, these are the most commonly used loan types, popular with lenders because of the insurance backing the loan, and popular with borrowers because these loans require as little as zero to 5% down, and have higher debt-to-income ratios. This means that a borrower may qualify for this type of loan even if they have very little cash for their down payment, have other debts already, and even if their credit score is not the best in the world.
Government insured loans backed by FHA are the loan of choice for the vast majority of first time home buyers. And if you are shopping for a home through a real estate agent, there is a very high probability that you’ll be steered in the direction of an FHA loan, or VA loan, if you are a veteran who qualifies for VA benefits. It’s important for consumers to be aware of the actual costs of these loans.
Along with your mortgage payment, which includes your principal and interest, there will be an escrow amount for property taxes and insurance. This is called the “PITI”, which stands for “Principal, Interest, Taxes & Insurance”.
In addition, this type of mortgage allows the borrower to pay a small down payment, of as little as 5% of the loan amount. Some even allow you to pay zero down, thus a borrower may finance 100% of the purchase price of the home. On the surface this looks great, but it comes at a steep price – Private Mortgage Insurance – which is added to the monthly payment in the form of a “Mortgage Insurance Premium”. The “MIP” as it is called, is a fractional percentage of the loan balance. Here is a quote from an article on hsh.com that details this item:
The upfront mortgage insurance premium is 1.75 percent of the loan amount, according to Dan Green, a loan officer in Cincinnati and author of TheMortgageReports.com. That’s $3,500 on a $200,000 mortgage loan. The annual mortgage insurance premium varies depending on your loan’s terms and loan-to-value ratio. In 2014, it can range from 0.45 percent to 1.35 percent of your loan amount.
Worst of all is that you now have to pay the annual FHA premium for the life of your loan. Before June 3, 2013, you were able to — in most cases — cancel your mortgage insurance premium after five to 10 years.
“Thanks to these changes, FHA loans have become expensive,” Fox says. “The upfront and annual mortgage insurance premiums are both at all-time highs.”
Here is how this looks when applied to an example home mortgage:
- Home Price: $150,000
- 30 year FHA mortgage
- 5% Down Payment = $7500
- Loan Amount = $142,500
- Interest Rate 5%
- FHA Private Mortgage Insurance Up Front Fee: 1.75% of the loan amount = $2493.75 (payable up front at closing. This will be part of your “closing costs”).
- FHA monthly insurance premium: 1.35% of the loan amount = $160.31. (remember this will be for the life of the loan – the entire 30 years!)
And for property taxes let’s use $1,400 and property insurance, let’s use $1,000
Your monthly loan payment would breakdown something like this:
- Principal and Interest: $764.97
- FHA PMI : $160.31
- Taxes: $116.66
- Insurance: $83.33
- Total Monthly Mortgage Payment: $1125.27
Your loan term is for 30 years, which is 360 payments, totaling $405,097.20
Combined with your original down payment of $7500 and your up front Private Mortgage Insurance Fee of $2493.75, you are looking at a total cost of: $415,090.95
The Private Mortgage Insurance alone could add up to $57,711 dollars to the cost of your mortgage!
(Plus, these numbers are simplified, and do not assume that taxes and insurance will go up, though they surely will).
So what may a borrower do to reduce these costs?
1. Pay as much for your down payment as possible, reducing the total loan amount.
2. If you are “cash poor” and do not have extra cash for a higher down payment, plan to prepay some additional principal each month, over and above your regular mortgage payment. Prepaying just $50 extra per month from the very first month will shave years of payments off of the end of your loan, significantly reducing your costs for interest and mortgage insurance premiums. This reduction is significant if you can prepay from your very first mortgage payment.
3. Try for a 15 year or 20 year term instead of a 30 year term. Borrowers think that they want the lowest payment possible, but taking a shorter term will not increase your monthly payment as much as you may think. Basically the longer the time frame of the loan, the more interest and mortgage insurance you will have to pay.
Insured mortgages have made it possible for more people than ever to obtain the financing to purchase a home. But at the same time, the “low-down-payment, long-term-financing” approach also leads to significant increases in ownership costs that have led in turn to more defaults and foreclosures. Once you understand the real costs involved in financing a home purchase, you can make smarter decisions that will help you pay for your home faster. And this is the sensible, low-stress way to home ownership.
About the author: Donna S. Robinson is a 18 year veteran of the real estate industry, with experience as a rehabber, wholesaler, investment analyst, rental property manager, owner, licensed agent and residential real estate market expert. She coaches real estate investors to improve cash flows while reducing risk. She has authored numerous books and courses on real estate market fundamentals and investing strategies. Follow her on twitter @donnaconsults Watch her videos here, and read more articles and contact her about coaching services on her website.