You’ve spent weeks preparing paperwork for your mortgage application. Now that you’re pre-approved for a loan, it’s time to talk numbers. At first glance of the document detailing the breakdown of your monthly mortgage payments, the term PMI catches your eye. It’s a little over $100 per month and you have no idea what it means.
From what you’ve read, it’s common on loans if the borrower puts little or no money down. But before you dive into panic mode, take a deep breath and read on to learn more about PMI and how it works:
What is private mortgage insurance (PMI)?
What happens when you don’t have the funds to make a 20 percent down payment on your new home? You may get approved for a loan, but you’ll pose more risk to the lender since you’re starting off with no equity in the home. And if you fall behind on payments and the lender forecloses on the home, they could stand to lose on the sale.
But the down payment of 20 percent is a way to create instant equity. It also provides a layer of protection for the lender if they have to sell at a discounted price to recoup losses.
So, how does the lender protect themselves if you make little to no down payment? That’s where PMI comes in.
PMI is a form of mortgage insurance that protects lenders from taking a huge loss if you default on the loan. If the lender is unable to recover the outstanding balance of the loan from the sale, PMI will kick in and pay out the difference.
Who pays for PMI?
This protection comes at a cost to borrowers. But it allows those with a down payment of lower than 20 percent to buy the home of their dreams. It also minimizes risk so lenders can extend these types of mortgage loans to consumers.
Does it cover private and public lenders?
PMI is only available to private lenders. Government agencies and other public lenders have their own form of mortgage insurance.
When is private mortgage insurance required?
Lenders use the loan-to-value (LTV) ratio to determine whether a borrower has to pay PMI. Typically, you’ll only have to pay PMI premiums if your loan-to-value ratio exceeds 80 percent. To calculate the mortgage loan-to-value, the lender divides the amount of the mortgage by the home value.
There are other circumstances that may cause the lender to require PMI coverage. This includes past foreclosures, less than perfect credit or any other factors the lender thinks will increase your chances of defaulting on the loan.
A few scenarios:
|Scenario 1||Scenario 2||Scenario 3|
|Home Value (also equivalent to sales price at the time of purchase)||$100,000||$200,000||$250,000|
|Loan to Value Ratio||90%
|PMI Required||Yes||No (unless the lender determines the borrower is riskier than normal)||Yes|
Private Mortgage Insurance vs Mortgage Insurance Premiums
As mentioned earlier, mortgage insurance comes in a few variations:
- Private Mortgage Insurance (PMI): protects private lenders who offer conventional loans. In most instances, PMI only applies until your LTV reaches 80 percent. But there are situations where the lender will require a higher percentage for the coverage to be lifted from the loan.
- Mortgage Insurance Premium (MIP): protects government-backed FHA and VA loans. It applies for the duration of the loan, even once LTV is below 80 percent.
The LTV ratio is computed in the same manner for both private and government-backed mortgage products.
How much is private mortgage insurance?
Premiums vary by loan. On average, you can expect to pay between 0.5 and 1 percent of the loan amount on an annual basis. So, if your mortgage is $350,000 and the PMI rate is 0.8 percent, your annual premiums will be around $2,800, or $233.33 per month.
The insurer will analyze your profile, including your credit score and down payment, to determine your rate.
The loan type could also impact your premium. For example, if you are taking out an Adjustable Rate Mortgage (ARM) with floating interest, your premium may be higher. Why so? If there’s a steep increase in interest, your monthly mortgage payments will rise. And there’s a possibility you’ll default on the loan.
The condition of the real estate market in your area could also impact your PMI premiums. If projections state home values will plummet in the future, your premiums may be higher. This is due to the likelihood of you walking away once you’re upside down on the loan.
How are premiums paid?
There are three ways to make PMI premium payments:
- Borrower-Paid PMI: Most lenders make it easy to manage premiums by rolling the monthly obligation into the amount you already pay for your home. This is the method used by most borrowers.
- Single Premium PMI: You can also make a single lump-sum payment at the start of the loan by paying cash or rolling sum of the premiums into the loan.
- Lender Paid PMI: If you wish to lower the monthly payment, Lender Paid PMI is also an option. The lender will pay premiums on your behalf. But keep in mind that the costs will be recouped in interest. And premiums don’t automatically go away when the mortgage LTV reaches 80 percent.
How to Avoid Paying PMI
The easiest way to avoid paying PMI is by making a larger down payment. If you can’t afford to put 20 percent down, it reduces your LTV ratio. Plus, you’ll be able to drop coverage quicker.
1. Take out a second mortgage or piggyback loan
To use this strategy effectively, you’ll need to take out a mortgage for the purchase price, minus 20 percent. The remaining balance, minus the down payment, is then rolled into a second mortgage or piggyback loan.
So, if you buy a home for $200,000 and make a down payment of $15,000, the first mortgage will amount to $160,000. The second mortgage will amount to $25,000 since you are making a down payment of $15,000.
With this method, you avoid paying PMI since the LTV ratio on the first mortgage is 80 percent. But keep in mind that second mortgages carry steeper interest rates. So, you’ll want to pay it off sooner than later to avoid spending a fortune in interest.
2. Monitor the loan-to-value ratio
When you took out the mortgage loan, your lender used the purchase price to determine the LTV ratio. However, an increase in the market value of your home could mean you are no longer obligated to pay for PMI.
By law, under the Homeowner’s Protection Act, PMI has to come off once the outstanding principal reaches 78 percent of the original value of the home.
Prepare to provide a professional appraisal to the lender to substantiate your claim. You may spend a few hundred dollars to get it done, but the cost savings will be worth it.
3. Request an earlier removal of PMI
If you’re nearing the 80 percent mark, the lender may be willing to remove PMI from your loan. There’s also a possibility that you’ve already met some other criteria that warrant the removal of coverage.
4. Refinance your mortgage
Perhaps your credit was in shambles and you were forced to take out a government-backed loan that requires you to carry PMI for the duration of the loan. Or maybe you got stuck with a conventional loan from a private lender that requires PMI until the LTV ratio reaches 70 percent.
Either way, refinancing your loan with laxer PMI restrictions may be a better option. But be sure to run the numbers to confirm that the new loan will not cost you more over time. (Remember, extending or resetting the loan term will give the lender more time to collect interest from you).
5. Do your research
Some lenders offer mortgage products that allow you to make a small down-payment and not have to pay for PMI. Bank of America’s “Affordable Loan Solution” mortgage product is a great example.
6. Ask about exemptions
If you’re a physician or veteran, you could also be exempt from PMI, even if you don’t put down 20 percent. Ask your lender for more details to determine if you qualify.
7. Consult with the lender
Still no luck? Reach out to the lender to inquire about other options to remove PMI from your loan. They may know of tips and tricks that may not be obvious to the average borrower.
Finally, if you still have questions or don’t quite understand how PMI works, seek clarification before signing on the dotted line. That way, you won’t be in for any surprises later on down the line.