When embarking on the journey of buying a new home, you will likely encounter a variety of financial terms and products that can seem daunting at first. Among these is Private Mortgage Insurance, commonly referred to as PMI. PMI is a critical component for many homebuyers who are looking to purchase a house without putting down a significant down payment. This article aims to demystify PMI and explain how it works, when it\'s required, and how you can eventually remove it from your mortgage payment.
What is Private Mortgage Insurance (PMI)?
Private Mortgage Insurance (PMI) is a type of insurance policy that protects the lender from the risk of default and foreclosure. When a borrower makes a down payment of less than 20% of the home\'s purchase price, the lender considers the loan to have a higher risk of default. To mitigate this risk, lenders require the borrower to purchase PMI.
PMI is usually paid monthly as part of the overall mortgage payment. The amount of PMI you\'ll pay depends on the size of the down payment and the loan, as well as the borrower\'s credit score and mortgage type. As a rule of thumb, the smaller the down payment and the lower the credit score, the higher the PMI premium.
When is PMI Required?
Lenders typically require PMI on conventional loans when the borrower makes a down payment that\'s less than 20% of the home’s value. However, it’s not unique to conventional loans. Government-backed loans such as FHA loans have their own mortgage insurance requirements, but these are not referred to as PMI.
The purpose of PMI is straightforward: it provides financial protection to the lender in case the borrower is unable to repay their loan. While it may seem like an unnecessary cost, PMI enables many individuals to become homeowners when they might not otherwise have the upfront capital to meet larger down payment requirements.
How Much Does PMI Cost?
The cost of PMI varies but is typically between 0.5% to 1% of the entire loan amount on an annual basis. So, for a $200,000 mortgage, PMI could cost between $1,000 to $2,000 a year, or approximately $83.33 to $166.67 a month. These premiums can either be paid along with your monthly mortgage payments or in some cases, upfront at closing.
It\'s important to understand that PMI does not provide any form of protection for the borrower. Its sole purpose is to protect the lender.
How Can You Avoid Paying PMI?
There are a few strategies that can help you avoid paying PMI:
1. Save for a larger down payment. If you can manage to save 20% or more for a down payment on your home purchase, you can typically avoid PMI.
2. Consider a piggyback loan. This involves taking out two mortgages simultaneously – one for 80% of the home’s purchase price and another for the remainder of the down payment, minus whatever cash you can contribute.
3. Some lenders offer lender-paid mortgage insurance (LPMI), where the cost of the PMI is included in the mortgage interest rate.
4. Veteran Affairs (VA) loans and United States Department of Agriculture (USDA) loans do not require PMI.
Removing PMI from Your Mortgage Payment
For homeowners with PMI, there is good news: PMI is not a permanent part of your mortgage payment. There are several circumstances under which PMI can be removed:
1. Once you\'ve reached 20% equity in your home through paying down your mortgage, you can request that the lender cancel PMI.
2. PMI is automatically terminated once you reach 22% equity in your home based on the original property value and on-time payments, as per the Homeowners Protection Act.
3. Home improvements or changes in market conditions can increase your home\'s value. If an appraisal confirms that the loan-to-value ratio is now below 80%, you can request to have PMI removed.
Private Mortgage Insurance is an essential tool for homebuyers who cannot afford a hefty down payment but want to purchase a home. Understanding what PMI is, when it applies, and how to remove it can save you money in the long run and help you manage your home financing more effectively. Remember that PMI should be viewed as a temporary cost that enables you to acquire a valuable asset - your home. As your home equity increases, you will have opportunities to eliminate PMI and reduce your monthly mortgage expenses. Always consult with a real estate or mortgage professional to explore your options and make informed decisions about PMI and your home purchase.
This article was contributed on Jan 24, 2024