How the Down Payment Affects Private Mortgage Insurance

This is part of an ongoing series that addresses common questions from home buyers. Today we have a two-part question: How does the down payment affect private mortgage insurance or PMI, and how much do I have to put down to avoid paying PMI?

The short answer: If you make a down payment below 20% when buying a house, you might be required to pay for private mortgage insurance. These policies are usually required when the loan-to-value (LTV) ratio rises above 80%. That’s the industry standard. You could avoid PMI by making a larger upfront investment.

PMI Trigger: A Loan-To-Value Ratio Above 80%

Private mortgage insurance, or PMI, is a special kind of insurance policy that protects mortgage lenders from losses resulting from borrower default (or failure to pay). It is the home buyer who typically has to pay for a PMI policy, even though it protects the lender.

When it’s required: Private mortgage insurance is typically required when borrowers take out a loan that accounts for more than 80% of the home’s value. This is often the case when a borrower makes a down payment below 20%. When the loan-to-value ratio rises above 80%, PMI is usually required.

So we’ve answered the first question: How does the down payment affect private mortgage insurance when buying a house? If you take out a single loan and put less than 20% down, you will likely be required to pay for PMI coverage.

On the other hand, if you put down more than 20% when buying a house, and thereby keep the LTV ratio at or below 80%, you should be able to avoid private mortgage insurance entirely.

And that answers the second question: How much of a down payment should I make to avoid paying for a PMI policy? If you are using a single loan to buy a house, an upfront investment of 20% or more will generally allow you to avoid this extra cost.

There are scenarios where a borrower could put down less than 20% and still avoid private mortgage insurance. Depending on the circumstances, this might be accomplished by “piggybacking” two different loans so that neither has an LTV above 80%.

To Be Clear, a 20% Down Payment Isn’t Always Necessary

A survey conducted by Realtor.com found that many home buyers think they have to put down at least 20% when buying a house. But this is simply not true.

These days, there are quite a few mortgage financing options that allow for a smaller down payment. The FHA loan program allows borrowers to put down as little as 3.5% of the purchase price. Some conventional (non-government-insured) mortgage loans allow for down payments as low as 3%.

Here are two examples of conventional home loan programs that allow for 97% financing:

  • Freddie Mac’s Home Possible Advantage® product fact-sheet states the following: “Minimum down payment of 3 percent allowed for Home Possible Advantage.”
  • Fannie Mae’s HomeReady® fact sheet says the program allows for “financing up to 97% loan-to-value (LTV) for purchase of one-unit principal residence.”

A study by Freddie Mac found that the average down payment among first-time buyers in 2016 was 6%. During that same year, the average upfront investment from repeat home buyers was 14%. This is further evidence that it’s not always necessary to make a down payment of 20% when buying a house.

Everything’s a Trade-off

Of course, if you do make a smaller investment, you could encounter private mortgage insurance. So there’s a very clear trade-off here.

The upside is that PMI coverage allows home buyers to purchase a house sooner, and with less money down. Without the private mortgage insurance industry, the low-down-payment financing options mentioned above probably wouldn’t be available anymore. Without PMI, most home buyers would be required to make an investment of 20% or more – and that would have a dramatic effect on the housing market by shrinking the pool of eligible borrowers.

Another advantage of making a larger down payment is that it reduces the size of your monthly payments. It’s simple math. The more you pay up front, the less you are financing. This results in a smaller mortgage payment each month.

There is a trade-off with almost every choice you make when taking out a home loan, and that goes for the down payment as well.