Making a downpayment of 20% or more can help individuals avoid mortgage insurance and start building equity and wealth faster.
Contrary to what you may hear, people with lower credit scores will still be paying a higher mortgage insurance rate than people with good credit.
Paying off credit card balances and other loans as much as possible can help individuals maximize their credit rating before applying for a mortgage.
Several clients have reached out recently because they’ve seen news reports about a "new" unfair tax on mortgage borrowers who have higher credit scores. Or maybe a young adult or close relative has asked if they should intentionally lower their credit score to get a better deal on a mortgage. Don’t do it!
Even with substantially higher mortgage rates than we’ve seen in recent years, housing in this part of the country is still very expensive and borderline out of reach for many young people. Townhouses and starter homes are in the $500,000 range and full-size single-family homes in our area average about $750,000. Even those with good, steady incomes and good credit can find it difficult to make the 20% downpayment ($100,000 to $150,000) required to avoid mortgage insurance.
A colleague of mine, Tyler Howe, a mortgage specialist at Finance of America Mortgage LLC, shared a (misleading) recent headline with me screaming: "620 FICO SCORE GETS A 1.75% FEE DISCOUNT" and "740 FICO SCORE PAYS 1% FEE."
This all has to do with changes to Loan Level Price Adjustments (LLPAs) imposed by Fannie Mae and Freddie Mac, the two entities that guarantee a vast majority of new mortgages. “LLPAs are based on loan features such as your credit score and the loan-to-value ratio among other things,” Howe said. “They've been changed several times over the years and a fairly substantial change was announced in January of this year.”
What Howe is referring to is also called mortgage insurance, which is the additional expense that homebuyers must pay if they put down less than 20% of the purchase price when buying a property. While the mortgage insurance attached to some home loans goes away after homeowners pay off a certain amount of their loan balance, mortgage insurance tied to FHA loans remains in force until the entire mortgage is paid off -- unless the buyer put down at least 10% at the time of purchase.
FHA mortgages are intended for low- and middle-income homebuyers, as they require lower down payments and allow for more flexibility on credit requirements than conventional mortgage loans do. FHA requirements include mortgage insurance for FHA loans in 2023 to protect lenders against losses that result from defaults on home mortgages. Again, mortgage insurance premiums are required when down payments are less than 20% of the appraised value. So, none of this applies to you or an adult child in your life if they can put down 20% or more for a downpayment to obtain a conventional mortgage. But even people with good credit may have trouble meeting the 20% threshold with today’s near record high housing prices and substantially higher mortgage rates. It’s even more challenging if they’re still paying off student loans, a major out-of-pocket medical expense, or caring for a special needs child. Again, we have a well-intentioned government policy that can cause more harm than good (remember the 2008 financial crisis?). For instance, the government is taking away the price adjustments that are imposed based on your credit and the loan-to-value ratio.
Why should people with good credit be penalized?
If you have a good credit score of 740 and a solid loan-to-value (LTV) ratio in the 80% to 85% range, your fee will be GOING UP to 1% from the current 0.25. By contrast, if you have a mediocre credit score of 640, your fee is GOING DOWN to 2.5% from 4.25%. The potential homebuyer with the weaker credit score is still paying 1.5% more; the government is simply trying to level the disparity between what people with good credit and lesser credit pay for mortgage insurance. Before the new rules went into effect, there was a spread of 4% between people with good credit and bad credit.
Again, if you or someone close to you is planning to buy a home, our recommendation is always to put down at least 20% so you can avoid the hassle of mortgage insurance and start building equity (and wealth) much faster. You may have to set your sights a little lower to meet the 20% downpayment threshold, but the savings and peace of mind are worth it. Over time, you can always expand or move to get the home you truly want.
And, by all means, pay off all of your credit card balances and other loans as much as you can so you can maximize your credit rating before applying for a mortgage. The savings, when compounded over the 15-to-30-year life of your mortgage can be eye-opening. So don’t be tempted to lower your income or lower your credit score, just to qualify for apparent mortgage assistance.
If you or someone close to you has concerns about your credit rating or mortgage, please don’t hesitate to reach out. We’re very experienced in this area and happy to help.
DAN SATZ MS, CFP® is a Wealth Manager at Novi Wealth