What Does a Mortgage Down Payment Mean & What is PMI?

After deciding to purchase a home comes the largest expense in the process: the down payment on the mortgage. The down payment is a percentage of the purchase price that gets paid upfront to the lender when closing on the loan and plays a role in determining interest rates and how much you will need to borrow to cover the cost of your new home. The remaining mortgage balance is the purchase price minus the down payment contributed.
Mortgage down payments are typically expressed as a percentage and represent the initial equity owned in the home after closing. Standard down payments are usually 20% of the purchase price, with the rest covered by the mortgage lender and repaid over time. With 20% down payments, the new homeowner owns 20% equity in their home upon completion of the sale. Every month, payments to the lender increase home equity past the initial investment made to get the house. Eventually, the homebuyer will own all equity in the home when the mortgage is paid off. Higher down payments represent a lower loan-to-value or LTV ratio, which makes lenders see you as a less risky borrower. While lower down payments are becoming more common, they continue to be viewed as risky to the lender. Lower LTVs mean that the buyer has more equity purchased in the home, while higher LTVs reflect low down payments and less equity in the home’s ownership.

Using a mortgage calculator can help buyers determine how their down payment will affect monthly payments over the life of their mortgage. Both monthly payments and the down payment should reflect the buyer’s lifestyle and income. Recommendations are that homebuyers should be able to typically afford homes with selling prices between 2 and 2.5 times their gross annual income, which leaves enough funds to cover expenses and room for buyers to save and meet other financial goals. Homebuyers should balance placing a high enough down payment on their new home to minimize monthly payments while maintaining enough funds to prepare for emergencies and additional expenses that arise throughout homeownership.
Typically, all mortgages require a down payment as a show of good faith to the lender. However, sometimes loans may not require down payments, such as some federally backed mortgages. VA mortgages for active-duty military personnel and veterans often do not have down payments. Similarly, USDA Rural Development mortgages do not require down payments to qualified homebuyers either. Other federal mortgages, like those from the Federal Housing Administration (FHA), allow for lower down payments. The FHA requires as little as 3.5% of the home purchase price and is suitable for buyers with lower credit scores. For buyers able to make medium down payments and have decent credit, FHA mortgages typically run more expensive than conventional loans. 

Private Mortgage Insurance

For buyers looking to purchase a home with a down payment of less than 20%, there is the possibility of doing so with the addition of PMI, or private mortgage insurance. PMI is designed to protect the lender in case the buyer is unable to continue payments, but does not offer any protection to the buyer. PMI helps home buyers to afford homes that they would not be able to afford if it was solely based on the amount they can pay down on the mortgage and their credit score. There are typically different methods of paying PMI available to buyers, such as monthly payments, upfront payments, or a combination of the two. For monthly payments of the PMI premium, the monthly insurance payment is included in the monthly mortgage payments. Upfront payments are paid at once when the sale is complete. The combination of monthly payments and upfront payments includes a portion of the premium due when the sale closes, the remainder due as part of the mortgage monthly payment each month. Average PMI rates typically range between 0.55% and 2.25% of the original loan amount each year until canceled and depend on factors such as credit score, loan history, and the total down payment intended. Mortgage PMI calculations are simple. Homeowners can take the amount of their mortgage and multiply it by their interest rate, dividing the result by 12 to determine the monthly payment. 

Once the homeowner has accrued 20% equity in the home, they can ask their lender to remove the PMI payment from their monthly mortgage. Once 22% equity is owned in the home, the loan servicers are required to cancel PMI. This requirement was outlined in the Homeowners Protection Act, passed in 1998, which eliminates unnecessary PMI payments. Before the regulation took effect, homeowners often had trouble canceling the insurance and even if the lender agreed to cancel, there was little that could be done if they decided otherwise. In this scenario, homebuyers could be stuck paying for PMI for decades longer than they intended or for the life of the loan. If looking to eliminate PMI sooner, homeowners can have their home reappraised to determine if they meet the 20% equity threshold at a new valuation, prepay loans to reduce the balance more quickly, or remodel to increase the home’s value. 
Homebuyers are increasingly looking to place down payments on their new home less than 20%. General real estate trends show a rise in average home prices, making new homeowners less able to afford to put 20% down on a house at signing. Studies have shown that the median down payment is less than 10%. Low down payments are especially useful in helping buyers achieve their dreams of homeownership, whether they have the cash for a large down payment or not. Potential homebuyers can use a mortgage payment and PMI calculator to determine the effect their anticipated down payment will have on the monthly cost and overall expenditures over the life of the loan.