PMI: How private mortgage insurance works and why it can benefit homebuyers

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Private mortgage insurance, also known as PMI, is generally required when you put less than 20 percent down on a home purchase. The extra charge helps offset the risk to your lender, and it’s especially common for  government-backed loans, such as FHA and USDA mortgages, which typically allow minimal down payments. In most cases you may need to make an upfront payment for your PMI at closing then additional monthly payments on top of payments towards your mortgage.

What is PMI?

This is a type of insurance that conventional mortgage lenders require when homebuyers put down less than 20 percent of the home’s purchase price. Borrowers with PMI pay a mortgage insurance premium, and its cost can vary by lender.

PMI protects lenders in case the homeowner defaults on the loan, and while it doesn’t protect the buyer from foreclosure, it does allow prospective homebuyers to become homeowners, even if they can’t afford a 20 percent down payment. If your lender determines that you’ll need to pay PMI, it will coordinate with a private insurance provider, and the terms of the insurance plan will be provided to you before you close on your mortgage.

When you have PMI, you’ll need to pay an extra fee every month in addition to your mortgage principal, interest and taxes. Your loan documents may also indicate when you’ll be able to stop paying PMI, usually when you have at built up equity equal to at least 20 percent of your home’s value. This usually means the remaining balance of your loan is 80 percent or less of your home’s total value.

How much does PMI cost?

According to the Urban Institute, the average range for PMI premium rates was 0.58 to 1.86 percent as of September 2020.  Freddie Mac estimates most borrowers will pay $30 to $70 per month in PMI premiums for every $100,000 borrowed.

Your credit score and loan-to-value (LTV) ratio have a big influence on your PMI mortgage premiums. The higher your credit score, the lower your PMI rate will usually be. A high LTV will also generally make your PMI payments more expensive.

A quick primer on LTV if you’re not familiar: the ratio is essentially how much you’re borrowing compared to the total value of the asset you’re purchasing, in this case, a house. Basically, the more you put down, the less you have to borrow, so the lower your LTV will be. If you put down 20 percent, your LTV is 80 and you don’t have to secure PMI. Anything less, and you probably will need the insurance, and the less you put down, the more insurance you’ll need to pay.

Here’s how it might play out:

Example A: Without PMI

House cost: $200,000

Down payment: $40,000 (20% of cost)

Interest rate: 4%

Monthly payment (principal and interest monthly): $763

Example B: With PMI

House cost: $200,000

Down payment: $20,000 (10% of cost)

Interest rate: 4%

PMI: $166 (1% of home cost)

Monthly payment (principal, interest and PMI): $1,025

How do I make PMI payments?

PMI payment options differ by lenders, but typically borrowers can opt to make a lump-sum payment each year or pay in monthly installments.

Most commonly, borrowers couple the cost of the premium with their monthly mortgage payment, so they pay an extra fee every month. Under this method, you’ll be able to find a full breakdown of the costs in your loan estimate and closing disclosure documents.

Some borrowers choose lump sum or “single-payment” mortgage insurance, instead, meaning they pay the full annual cost of their PMI up front. The lump sum option is probably not a good idea if you’re thinking of moving or refinancing your mortgage, because the payment is not always refundable, even if you no longer hold the mortgage it was applied to.

The third option is a hybrid which allows you to make a partial upfront payment and roll the rest into your monthly mortgage bill. Your lender should tell you the amount of the upfront premium then how much will be added to your monthly mortgage payment.

Ask your lender if you have a choice for your payment plan, and decide which option is best for you.

Mortgage insurance will stop being tax deductible at the end of 2020.

Do all lenders require PMI?

As a rule, most lenders require PMI for conventional mortgages with a down payment less than 20 percent. However, there are exceptions to the rule, so you should research your options if you want to avoid PMI.

For example, there are low down-payment, PMI-free conventional loans, such as PMI Advantage from Quicken Loans. This lender will waive PMI for borrowers with less than 20 percent down but they’ll bump up your interest rate, so you need to do the math to determine if this kind of loan makes sense for you.

If you’re eligible, VA loans don’t require PMI, which is helpful for homebuyers who don’t have enough saved up to make a large down payment.

Other government-backed loan programs like Federal Housing Administration (FHA) loans require their own mortgage insurance, though the rates can be lower than PMI. In addition, you won’t have an option to cancel the insurance even after you reach the right equity threshold, so in the long term, this can be a more expensive option. Your credit score won’t affect the insurance rate for FHA loans, though it could be higher if you put down less than 5 percent.

Best practices to implement before you choose a lender

  1. Shop around. Don’t agree to a mortgage without comparing offers from at least three different lenders. That way you can try to get the best rates and terms for your specific financial situation.
  2. Bump up your down payment. If you can spend a little extra time saving for a minimum of a 20 percent down payment, you’ll be able to lower your monthly payments in the long run. Buying a less-expensive house is another option to avoid PMI.
  3. Consider other types of loans. While conventional loans are the most popular type of home financing, they’re just one of many options. Look at FHA, VA and other types of home loans to make sure you’re getting the right one for your situation.

Is there any advantage to paying PMI?

PMI is a layer of protection for lenders, but an added expense for you as a borrower. However, that doesn’t mean it’s all downside for homebuyers.  PMI might allow you to purchase a home sooner because you won’t have to wait to save up for a 20 percent down payment. If your credit score is high and your LTV is relatively low, you should be able to get a low PMI rate, which will make your mortgage more affordable overall.

In some cases, paying PMI can even help you build wealth faster. Homeownership is usually seen as an effective long-term wealth building tool, so owning your own property as soon as possible lets you start building equity sooner, and your net worth will expand as home prices rise.  If home prices in your area rise at a percentage that’s higher than what you’re paying for PMI, then your monthly premiums are helping you get a positive ROI on your home purchase.

Once you’ve reached 20 percent equity — either through paying down your loan balance over time or through rising home values — you can contact your lender (in writing) about removing PMI from your mortgage. Loan servicers must terminate PMI on the date that your loan balance is scheduled to reach 80 percent of the home’s original value.

How do I 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 a government-insured loan. Loans backed by the U.S. Department of Veterans Affairs and the U.S. Department of Agriculture do not require mortgage insurance. FHA loans, however, do come with two types of mortgage insurance premiums — one paid upfront and another paid annually.
  3. Cancel PMI later. If you already have PMI, keep track of your loan balance and area home prices. Once the loan balance reaches 80 percent of the home’s original value, you can ask the lender to drop the mortgage insurance premiums.

Private mortgage insurance adds to your monthly mortgage expenses, but it can help you get your foot in the homeownership door. When you’re buying a home, check to see if PMI will help you reach your real estate goals faster.

With additional reporting by Sarah Li Cain.

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