Most borrowers know that if they put less than 20% down on a home, they are going to pay PMI. This pertains only to conventional loans though. You may know these loans as Fannie Mae or conforming loans. You pay the insurance on these loans until you owe less than 80% of the home’s value.
USDA loans work differently. First of all, you don’t need a down payment. You can borrow up to 100% of the home’s value. Second, you don’t pay Private Mortgage Insurance. You do pay an annual fee, though. While it’s similar to the mortgage insurance, it’s much lower than PMI and you pay it for the life of the loan.
What is the USDA Annual Fee?
The USDA charges 0.35% of the loan balance on an annual basis. You pay the fee monthly, though. For example, if you borrow $100,000, your annual fee would be $350, but you would pay it in monthly increments of $29.
Let’s compare this to the PMI you would pay on a conventional loan. It’s impossible to know exactly how much you would pay in mortgage insurance because it’s based on your LTV and credit score, but in general, borrowers pay between 0.5% and 1% for this insurance. This means on a $100,000 loan, you’d pay between $500 to $1,000 per year for the insurance.
The Upfront Fee
The USDA also charges an upfront guarantee fee. This is how the USDA is able to guarantee the funds for ‘risky borrowers’. The fee recently came down. It now costs borrowers 1% of the loan amount at the closing. You are able to finance this fee with the loan, which means you might have an LTV slightly higher than 100%. This does not affect your chances of securing the loan, though.
The USDA charges the guarantee fee as a way to fund the ‘bail outs’ they need to pay certain lenders. As careful as the USDA is with their guidelines, there are still defaults that occur. When they do, the USDA pays the lender a portion of the funds (the amount they guaranteed). This helps the lender be able to write loans for less than perfect borrowers.
The USDA Guidelines
It will all make sense when you see what the USDA requires. The requirements are much less stringent than the conventional guidelines starting with the 100% financing they offer. The USDA requires the following:
- 640 credit score
- Maximum housing ratio of 29%
- Maximum total debt ratio of 41%
- Stable income
- Stable employment
- No defaults on previous federal loans
- You must live in the home as your owner-occupied property
One other factor that sets this loan apart is the eligibility for the program itself. Before you can even see if you qualify, you must prove that your total household income does not exceed 115% of the average income for the area. The USDA tallies the total household income whether or not everyone is on the loan. For example, if you have your parents living with you and they still work, their income will count towards eligibility. It does not count towards your qualifying income, though, unless they are on the loan.
The Conventional PMI Difference
So how is conventional loans PMI different? First, it’s insurance that covers the lender only. If you default on the loan, the insurance pays the lender back some of the money they lost. The lender requires this for any loans over 80% LTV. But, you can cancel the insurance.
By law, the lender must cancel it once you owe 78% of the original value of the home. But, you do have the option to request early cancellation if you know your home appreciated or if you paid the principal balance down faster than the loan required. If you know you owe less than 80% before the actual date your amortization table suggested you would be at this point, you can request cancellation of the insurance in writing. The lender will then determine if you do owe less than 80% by requiring an appraisal or by calculating your outstanding principal balance against the original value, if you paid extra money towards the principal.
The USDA does not charge PMI, which can be a great way for you to save money. Even though they do charge a guarantee fee, it’s much less than what you would pay for a conventional loan. You are only eligible for a USDA loan if you are not eligible for any other loan type, including the conventional loan. Either way, make sure you shop around and find the right USDA lender with the lowest fees and best interest rates.