What Is Private Mortgage Insurance (PMI), and How Can You Avoid It?
Suppose you're considering purchasing a home or taking out a mortgage. In that case, you may have heard of the term "PMI" or private mortgage insurance. But what exactly is PMI, and how does it impact your home-buying journey? When borrowers do not have a down payment of 20% of the home's purchase price, lenders often require them to purchase PMI or Private Mortgage Insurance. It protects the lender against defaults by borrowers. Throughout this article, you will learn what PMI is, how it works, and how to avoid it. If you are looking to refinance or are a first-time home buyer, read on for more information about PMI and its implications.
What Is PMI?
Private mortgage insurance (PMI) is a form of mortgage insurance usually required by borrowers of conventional loans. Once you stop making payments on your loan, PMI protects your lender. If you are buying a home with less than 20% down, PMI may be required as part of your mortgage payment.
Once you've accepted your home, you can usually request to stop paying PMI when you reach 20% equity. The PMI is often automatically canceled once you get 22% equity. For instance, buying a home for $200,000 will require a down payment of $40,000 to avoid paying PMI.
The PMI is only applicable to conventional loans. Some types of loans also include mortgage insurance. An FHA loan, for instance, requires mortgage insurance premiums (MIP), which differ from PMI.
How PMI Works
The loan-to-value (LTV) ratio is one measure of risk that lenders use when underwriting mortgages. The LTV is the ratio of the loan amount to the home's value. Mortgages with an LTV ratio greater than 80% require the borrower to have PMI since they are considered more likely to default.
In most cases, PMI is paid monthly as part of the mortgage payment to the lender, but sometimes it is paid up-front at closing. It is possible to remove PMI from a mortgage after a borrower has paid down enough of the principal amount.
Suppose the borrower pays their mortgage on time. In that case, their lender must terminate PMI when the loan balance reaches 78% of the house's original value (or when equity reaches 22%). Borrowers who have paid enough toward the principal amount of their loan (the equivalent of that 20% down payment) can ask their lender to remove the PMI.
The Cost of PMI
PMI costs can significantly increase a mortgage payment. In general, PMI costs range from 0.5% to 2.5% of the entire mortgage loan amount annually, depending on the amount of the loan and your credit score. For example, suppose you had a $200,000 loan with a 1% PMI fee. A fee like this would add approximately $2,000 to the cost of your mortgage each year, or $166 per month.
For many people, PMI is essential to buying a home, especially for first-time buyers who need more funds to cover a 20% down payment. Because of this cost and the difficulty of canceling PMI, some people may avoid taking out this insurance. Buyers eager to own their own home may find it worthwhile to purchase this insurance.
You will not be protected by PMI if you fall behind on your payments, the borrower, and you could still lose your home to foreclosure if you fall behind on your payments.
Mortgage Insurance Vs. Homeowners Insurance
There is a common misconception that mortgage insurance is the same as homeowners insurance. However, each serves a different purpose. A homeowners insurance policy protects you if your property is damaged. In contrast, a mortgage insurance policy makes getting a mortgage with a lower down payment easier.
What Influences Your Private Mortgage Insurance Requirements
As part of your regular mortgage payment, your lender will consider several other factors when determining how much PMI you should pay. Here are a few of the important things that you should take note of.
Down Payment Amount
Your down payment will significantly influence how much PMI you must pay. In the event of a default on a mortgage, your home goes into foreclosure, and the lender will lose more money if you have a smaller down payment.
If you make a smaller down payment, your regular mortgage payments will be higher, and you will have to wait longer to be able to cancel your PMI. There is a bigger chance that you will miss a payment, leading to a higher PMI rate.
Whether or not you can afford a down payment of 20%, you can reduce how much PMI you must pay by increasing your down payment.
A lender will review your credit history to determine if you have been a responsible borrower. If you borrowed money, your credit score indicates how reliable you have been at repaying it. Having a higher credit score, for example, can show that:
- You pay more than the minimum payment on your accounts and credit cards regularly.
- You borrow no more than you can afford to repay.
- You are on time with your payments.
- You stay within your credit limit.
In cases where you have a high credit score and a strong credit history, you may qualify for a lower PMI premium because a lender knows you are a responsible borrower.
On the other hand, lenders may have less trust in you if you have a low credit score. Therefore, you may have to pay higher PMI premiums.
Type of Loan
You may have to pay PMI based on your loan type. Fixed-rate loans, for instance, reduce risk because the rate will not change, resulting in consistent mortgage payments. Mortgage insurance rates can be lower when there is less risk, so you may not have to pay as much PMI.
Adjustable-rate mortgages, or mortgages whose rates can change based on the market, carry more risk because it is harder to predict future mortgage payments. With ARMs, the mortgage insurance rate could be higher. However, ARMs are typically cheaper than fixed-rate mortgages, allowing you to pay more toward your principal, build equity more quickly, and reduce your PMI.
Many factors can influence how much PMI you'll have to pay. A lender can help you understand your loan options and how much PMI you'll need to pay.
How To Avoid PMI
Your options for avoiding PMI depend on your type:
- Borrower-paid private mortgage insurance, which you'll pay with your mortgage payment.
- Lender-paid private mortgage insurance, for which your lender pays upfront, and you pay back by accepting a higher interest rate.
Now let's examine how each type works and how you can avoid paying.
How To Avoid Borrower-Paid PMI
Borrower-paid PMI (BPMI) is the most common form of PMI. With BPMI, you pay an insurance premium on top of your regular mortgage payments. Here are some tips for avoiding PMI for home buyers.
Make A Large Down Payment
If you are paying a down payment of at least 20% on your home, you can avoid BPMI altogether or request to remove it once you reach 20% equity. As soon as you hit 22%, BPMI is usually automatically removed.
Take Out An FHA Or USDA Loan
You can avoid PMI by taking out a different type of loan. Still, the Federal Housing Administration (FHA) and the U.S. Department of Agriculture (USDA) each have their mortgage insurance equivalents. Furthermore, these fees typically last for the lifetime of the loan.
There is an exception with FHA loans where the down payment or equity is 10% or more. For these loans, you will need to pay MIP for 11 years. Otherwise, you will have to pay these premiums until you refinance the house, pay it off, or sell it.
Take Out A VA Loan
VA loans are the only loans that do not require mortgage insurance. VA loans have either a one-time funding fee or an amount built into the loan amount instead of mortgage insurance. VA funding fees are also known as VA loan mortgage insurance.
There are various funding fees, ranging from 1.25% to 3.3% of the loan amount. The size of the funding fee varies depending on your down payment or equity and whether it is your first or subsequent loan. There is always a 0.5% funding fee on VA Streamline Loans, which are also known as Interest Rate Reduction Refinance Loans.
Let's say you receive VA disability or you're a surviving spouse of someone who died as a result of a service-connected disability. If that is the case, you do not have to pay the funding fee.
Take Out A Piggyback Loan
Piggyback loans are another option for avoiding the PMI associated with conventional loans. You pay for a down payment of around 10% or more and take out a second mortgage to get to 20% equity on your mortgage, usually through a home equity loan or HELOC .
Even though a HELOC can help avoid PMI, you are still responsible for making second mortgage payments. You will have two charges, but the double mortgage rate will be higher because your primary mortgage gets paid first if you default. Therefore, before you make PMI payments, you need to calculate whether you'll save money or if it's just a good investment.
How To Avoid Lender-Paid PMI
You can also have your lender pay your mortgage insurance premiums at closing. You will have to accept a higher interest rate in exchange. If you pay the PMI in full at closing, an interest rate increase won't be required.
Refinancing to a lower interest rate is the best way to lower your mortgage payments rather than removing mortgage insurance. However, you must keep the lender-paid PMI (LPMI) because it is a lump-sum payment. PMI may be cheaper than BPMI, depending on mortgage insurance rates at the time.
You will have to pay for LPMI if your down payment falls below 20%. If you choose BPMI, you will not pay the higher rate, but you will pay it monthly until you reach at least 20% equity in your home. If that happens, you're back to the amount from the BPMI scenario.
The Bottom Line
When a homebuyer does not have enough money to make a 20% down payment, PMI can be a costly necessity. You can avoid PMI by taking out a primary mortgage and a smaller loan to cover the 20% down payment. However, for first-time homebuyers, private mortgage insurance may be worth the extra cost. Your loan and financial situation determine your PMI rate, how long you must pay, and whether BPMI or LPMI is better. Find out how your lender handles mortgage insurance and how much PMI - or another type of mortgage insurance - you may have to pay.
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