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The traditional down payment is equal to 20 percent of the loan's value. That large amount paid upfront reduces the risk of default. Yet most first-time homebuyers today are not able to contribute a full 20 percent. To reduce the risk of these loans, lenders require borrowers to pay private mortgage insurance (PMI) until they earn roughly 20 percent in equity in their home. In addition, even though the homeowner pays the premiums, the insurance actually protects the lender. If the borrower defaults on the loan, the insurance will reimburse the lender for the associated losses.
Since PMI typically works out to be about one-half of one percent of the loan value, it can add up quickly. There are a few ways to avoid paying this extra fee without having making a 20 percent down payment. The first way is to finance your home purchase with an “80-10-10” loan. This calls for a 10 percent down payment and two loans, one funding 80 percent of the loan value and the other for the remaining 10 percent. Although the interest rate on the second mortgage loan is much higher than the first, the total monthly payment is less than the payment for a traditional loan that includes PMI.
The second possible way to get around the PMI requirement is to agree to pay a higher interest rate. While this may seem foolhardy, paying as much as 0.75 or 1 percent more can actually be less expensive because mortgage interest is tax deductible while PMI is not deductible in all cases.
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