Private mortgage insurance (PMI), is a way for many homebuyers to be able to purchase their dream home, with a lower downpayment than many may expect.
If you want to make your dream of home ownership a reality, it may be important to understand PMI — including what it is, how it works, and when borrowers do and do not need it.
What is Mortgage Insurance?
Oftentimes, homebuyers won’t be able to afford a 20 percent downpayment on the property of their dreams. In fact, it’s quite common to put less than 20 percent down. A recent study found that 60 percent of home buyers were able to finance their home purchase with a downpayment of 6 percent or less. Similarly, in 2017, the median down payment on a home was 10 percent, according to a Motley Fool report.
In cases where buyers are in a good position to make a purchase, but can’t quite reach that 20 percent downpayment, a lender or mortgage backer may require private mortgage insurance, or PMI, as a condition of granting a conventional loan.
Though it is paid by the buyer, mortgage insurance is really protection for the lender. By paying their insurance premium, buyers give their lender or mortgage backer assurance that they made a sound financial decision by granting the loan, despite the initial risk that may come with a lower downpayment.
Mortgage insurance then offers lenders a degree of financial protection in the event that you ever default on your loan, causing the investor to have to foreclose on or resell the property.
How Does Mortgage Insurance Work?
PMI is generally a prerequisite for conventional loans, if the buyer cannot afford a 20 percent downpayment. But it’s important to realize that PMI, like the mortgage loans it helps insure, is not “one size fits all.” The cost of PMI will vary, and there are different ways of structuring your PMI payments.
The price of PMI
Broadly speaking, the annual cost of PMI may range from anywhere from .02 percent of the amount of your loan, to more than 1 percent. The amount you may need to pay will vary from lender to lender, and will be affected by a number of factors unique to you, including:
- The amount and terms of your loan
- Your credit score/credit history
- Type of mortgage loan, such as fixed rate, adjustable rate, etc.
- Your loan-to-value ratio, or the amount of money you’ve borrowed versus the value of the property. This ratio will become more favorable to you, as you build more equity.
Different types of mortgage insurance
It’s also important to keep in mind that there are different methods you may use to pay your PMI.
- Monthly installments. In this arrangement, you pay PMI premiums every month, along with your loan payments, until your principal falls to a low enough level to cancel your remaining PMI. This is the most common way that many buyers pay their required PMI.
- Single premium PMI. With a single premium, you may pay the amount of your PMI off in one large lump sum. This means you will not have to pay a monthly insurance premium, and will have lower payments down the line, as a result.
- Split premium PMI. In this arrangement, you pay a lump sum upfront at closing, as a portion of your PMI premium. The remainder can then be paid down in monthly installments over time. These monthly payments will typically be significantly less than what you may have faced without that initial lump sum.
- Lender-Paid PMI (LPMI). Most commonly, PMI is paid by the borrower. However, in some cases, homebuyers may be able to agree to paying a higher mortgage rate, in exchange for their lender paying for PMI, which they typically buy out in a lump sum. Unlike borrow-paid PMI (BPMI), LPMI will raise your mortgage rate — and the amount you pay every month — for the entire life of your loan.
What About Government-Backed Loans (FHA, VA, etc.)?
So far, we’ve been discussing private mortgage insurance, which may be required as a condition for conventional mortgage loans. But what about other types of mortgage loans, such as FHA, VA, and USDA loans, which are issued and backed by the government, rather than a third party mortgage lender?
In most cases, these loans are also going to require some sort of mortgage insurance, but it works differently than PMI. It may go by a different name, may only be paid in one lump sum upfront, or may ultimately get rolled into your monthly mortgage costs.
FHA loans, for instance, are secured by FHA mortgage insurance, to be paid in part both upfront at closing, and as a regular premium, which gets added to your monthly mortgage payments. Similarly, VA and USDA loans need to be protected. Insurance for USDA-backed loans work similarly to FHA-backed loans. VA loans, however, don’t require mortgage insurance per se, but rather a one-time funding fee, to be paid upfront.
Can I Get Out of Paying Mortgage Insurance?
Is private mortgage insurance a fact of life? Not necessarily.
Remember, most homebuyers will only have to face the prospect of paying PMI if they cannot reach a 20 percent downpayment on their home. If you can afford to hold off on purchasing a home until you’ve saved more money, or if you can find a way to increase your downpayment amount — such as getting a personal loan from family, for example — then you may be able to avoid the costs of PMI entirely. In other cases, you may be able to restructure or find an alternative loan, in order to avoid paying PMI. There are also many downpayment assistance programs that may be able to help, available on the city, state, and national level.
In other cases, it’s important to remember that your PMI will typically not last for the entire life of your loan. There are a few ways to relieve yourself of PMI premiums over time:
1.) Automatically drop your PMI by building sufficient home equity
Federal law dictates that PMI automatically comes off when your loan amount reaches 78 percent of the home value. In other words, once you build 22 percent equity in your home, your monthly PMI should be canceled automatically by your lender. You may need to remind your lender or bank to cancel your PMI once you’ve reached 22 percent equity; in some cases, this step may get overlooked, leaving you on the hook for payments for longer than is necessary.
2.) Cancel your PMI by contacting your lender
You can also proactively reach out about canceling your PMI once your loan balance reaches 80 percent. Once you’ve reached 20 percent equity, you can typically ask your lender to drop mortgage insurance premiums. Canceling your premiums may be subject to a new independent appraisal, proving that your equity position really does exceed 20 percent.
3.) Refinance to relieve your PMI
If your home has appreciated significantly in value, or if interest rates have decreased due to economic activity, you may consider refinancing your mortgage. Refinancing may help eliminate your PMI premiums. Over time, your loan-to-value ratio may decrease due to changes in the value of your home, whether that’s due to upgrades you’ve made, or changes in your local market. Be sure to keep this in mind. As your loan-to-value ratio changes, you may be closer to automatically eliminating PMI than you might think, without having to go through the refinancing process. In other cases, refinancing may be a sound decision. Making the right move for your household is going to depend largely on your unique personal circumstances.
Making Mortgage Easier
Securing a loan and purchasing a home — these are some of the biggest financial decisions you may ever make. Wouldn’t it help to have an experienced professional on your side, at every step of the way?
At Baird & Warner, we know that there’s a lot that goes into financing your home purchase. That’s why, for the past 30 years, Baird & Warner has been offering residential sales, mortgage, and title services all under one roof — because we know it gives our clients an easier experience.
To understand all of your options and help determine which strategy will be the right fit for you, don’t hesitate to get in touch with your local Key Mortgage loan officer. Your personal Key Mortgage loan officer and their team can guide you through the loan process, from your initial application all the way through to closing. Along the way, this knowledgeable guide can help you save money and understand all the different financing solutions available to you, so that you can make the decisions that will benefit you and yours in the short term, and for years to come.
Bottom line? It’s mortgage made easier. Want to keep the financing conversation going? Don’t hesitate to get in touch with your local Key Mortgage representative.