When you’re looking to buy a home, a 20 percent down payment is recommended. While it’s not wrong to have a smaller down payment — you’ll still be able to buy a home — it does have some drawbacks. The biggest is the need for costly private mortgage insurance, or PMI.
What is private mortgage insurance?
Private mortgage insurance is a type of insurance you may be required to pay for when you take out a conventional home loan.
If you’re buying a home, lenders require PMI as part of a conventional loan to protect them in case you end up in foreclosure. The insurance protects the lender for at least some of the shortfall if the home is sold in foreclosure at less than the outstanding amount of the mortgage. PMI is generally required if you refinance your mortgage with less than 20 percent equity.
The good news is that having PMI can help you qualify for a mortgage if you otherwise couldn’t — especially if you don’t have a 20 percent down payment. But not everyone can get a conventional loan; many require good credit scores to get approved.
Should you avoid PMI?
PMI is a layer of protection for lenders, but an added expense for you as a borrower. Conventional loans are the most popular type of mortgages, but they’re also the one that isn’t insured by the government.
Once you’ve paid 20 percent of your home’s loan-to-value ratio, you can contact your lender about removing PMI from your mortgage payment. Keep in mind that PMI doesn’t go away automatically; you must request it.
While PMI is required for some loan agreements, it’s not for all. Here are a few ways to avoid private mortgage insurance:
1. Put 20 percent down. The higher the down payment, the better. At least a 20 percent down payment is ideal if you have a conventional loan.
2. Consider an FHA loan. The minimum down payment for an FHA loan is 3.5 percent. This is a good option if you have less-than-stellar credit, but the closing process could take a little longer with this option, and FHA loans have higher fees.
3. Cancel PMI later. If you couldn’t get out of private mortgage insurance when you bought your home, keep track of your payments. Once the loan balance reaches 80 percent of the home’s value, you can ask the lender to drop the mortgage insurance premiums.
How much does PMI cost?
PMI is typically an annual premium of .05 percent to 1 percent of the original loan amount per year, depending on the size of the down payment and your credit score. For example, if the home price is $200,000 and your PMI is 1 percent, you’re going to pay $2,000 a year, or a bit more than $166 a month.
There are a few different ways to pay for PMI, including:
1. Monthly. Most PMI policies require you to make monthly payments. This is an additional charge added onto your monthly mortgage bill.
2. One large payment. Sometimes, lenders require PMI to be paid in full at the time of closing. You can see if yours does in your loan estimate.
3. Both. Sort of like a down payment, you might be able to pay some of your PMI upfront and the rest in your monthly mortgage payment.
Mortgage insurance paid in 2018 is tax-deductible under the Tax Cuts and Jobs Act.
How do you know if you should get PMI?
Getting private mortgage insurance is typical for conventional loans, but you might not need to get it. Make sure you’re considering all your options before agreeing to get PMI. Some factors include:
1. Shopping around. If you settle for the first lender you get approved from, you might end up paying more in interest and insurance. Don’t agree on a mortgage without going over many different options first.
2. Bump up your down payment. Remember that 20 percent eliminates PMI. If you can spend a little extra time saving for a higher down payment, you’ll be able to lower your monthly payments in the long run. Buying a cheaper house is another option to avoid PMI.
3. Review other types of loans. While conventional loans are the most popular, they aren’t the only kind. Look at FHA, VA, and other types of home loans to make sure you’re getting the right one for your situation.
Private mortgage insurance can add to your monthly expenses. When you’re buying a home, check to see if PMI makes sense.