Mortgage 101

What is PMI?

It is important to know if and when private mortgage insurance (PMI) is necessary once you decide to buy a home


​​Unless you pay for a home solely with cash, you will need to apply for a mortgage, which is a type of loan that can be provided to you by a bank or similar financial institution. Depending on the type of mortgage that you select, you may need to obtain private mortgage insurance before the mortgage is finalized. However, this insurance isn't always required, which is why it's important that you understand what PMI is before you apply. This article offers a more comprehensive guide on private mortgage insurance and how you can avoid it.

 

What Is PMI?

 

Private mortgage insurance is a commonly required type of insurance that you may need to pay when applying for a conventional mortgage. Loaning any amount of money comes with a certain amount of risk to the lender. When providing borrowers with conventional mortgages, lenders seek to lessen this risk by requiring private mortgage insurance in many situations. As such, it's important to understand that private mortgage insurance protects the lender instead of protecting your investment.

If ever you stop making payments on your loan, the insurance that you purchase will make sure that your lender is properly protected from substantial losses. As the name implies, you can purchase this insurance from various private insurance companies. If you end up applying for a conventional mortgage, PMI insurance will likely be needed if you intend to make a down payment that's less than 20% of the home's sale price.

Let's say that you're buying a home that costs $400,000. If your down payment is less than $80,000, you will likely be required to obtain private mortgage insurance before a loan will be granted. This form of insurance is also necessary for people who are refinancing their current mortgage. If your equity is lower than 20% of your home's current value when you decide to refinance, you will need to obtain private mortgage insurance.

 

Is PMI Always Required when Paying Less than 20%?

 

The vast majority of mortgage lenders require borrowers to obtain private mortgage insurance if their down payment is less than 20%. There are, however, ways that you can avoid paying for private mortgage insurance even if your savings don't total 20% of the home's value.

 

How Much Does PMI Cost?

 

When you purchase PMI insurance, you will be tasked with paying a monthly premium for the insurance, which usually ranges from 0.58%-1.85% of the original loan amount. For every $100,000 that you borrow, you will most likely need to pay around $30-$70 per month. The total amount that you pay for private mortgage insurance depends on your credit score and your loan-to-value ratio.

Your credit score and credit history play a substantial role in determining how much you pay for this type of insurance. A higher credit score means that you will be able to obtain a mortgage at a lower interest rate even if your down payment is low. On the other hand, a lower credit score between 620-680 means that your interest rate will be considerably higher. To that end, your monthly mortgage payments will be higher since you'll need to pay a sizable amount of interest alongside your insurance premium.

The loan-to-value ratio that you have can also dictate what the cost of private mortgage insurance will be. When you put down 10% on a home, your loan-to-value ratio is 90%. A down payment of 15% results in a loan-to-value ratio of 85%. Smaller down payments result in the lender taking on more risk, which will lead to your PMI payments being higher.

 

Types of PMI

 

There are five types of private mortgage insurance that you could purchase when applying for a mortgage. The type that you select largely depends on your financial situation as well as the type of mortgage that you're looking to obtain. The five types of PMI include:

  • Borrower-paid PMI

  • Lender-paid PMI

  • Single-premium mortgage insurance

  • Split-premium mortgage insurance

  • FHA mortgage insurance

Borrower-Paid PMI

 

When you're required to obtain this form of private mortgage insurance, you will be expected to pay the PMI premium on a monthly basis. This premium will show up as part of your monthly mortgage bill. Your mortgage bill will also contain the principal and interest of your loan, property taxes, and any other costs that apply to your situation. You'll be notified that you've made a "special payment" each month, which means that the money has gone through.

 

Lender-Paid PMI

 

Even though you might find it beneficial to avoid paying for private mortgage insurance, having the lender pay for your insurance isn't entirely beneficial to you. As mentioned previously, your interest rate will likely be higher to compensate for the added costs to the lender. It's also possible that you will need to pay more loan origination fees before you can obtain your mortgage.

 

Single-Premium Mortgage Insurance

 

Instead of tasking you with paying a monthly premium for your private mortgage insurance, this form of PMI will bundle all insurance costs into a single payment. It's common for this payment to be made when closing occurs. However, you could also choose to roll it directly into your loan, which means that the loan will have a higher balance that you will need to eventually repay.

 

Split-Premium Mortgage Insurance

 

When you select this type of private mortgage insurance, your upfront insurance fee will be relatively high. As a result, the monthly insurance premiums you pay will be considerably lower than they otherwise would have been.

 

FHA Mortgage Insurance

 

If you seek an FHA loan from the Federal Housing Administration, you will need to pay for this type of mortgage insurance. Along with an upfront payment, you will need to pay monthly premiums throughout the course of the loan. Unlike standard private mortgage insurance, you won't be able to cancel FHA mortgage insurance.

 

How to Avoid PMI

 

As touched upon earlier, there are several things you can do to avoid paying for PMI. First, you could consider borrowing money from other sources to reach the 20% that you need, which could be your friends or family. It's also possible to get the lender to pay for this insurance in certain situations. Some lenders will make agreements with borrowers to forego the PMI requirement in lieu of a higher interest rate, which could end up being less than what you would pay for insurance.

If you can't find anyone you know who will lend you money or you don't want to have higher interest rates, the easiest way to avoid private mortgage insurance is to make a down payment of at least 20%. If you don't have enough money in your savings to make this sizable of a down payment, you could rethink purchasing a home at the moment to save for another 6-12 months. It's also possible for you to purchase a lower-priced home, which would make it easier for you to provide your lender with a down payment of at least 20%.

 

Taking Out a HELOC or Second Mortgage

 

Another option for avoiding private mortgage is to take out a HELOC or second mortgage. Let's say that your initial down payment is 10%. You could reach the 20% requirement for avoiding PMI by obtaining a second mortgage, which is available in the form of a home equity line of credit. This line of credit could provide you with enough funds to pay for the additional 10% that you require.

However, there are some downsides to this option. While you will be able to avoid paying for private mortgage insurance, it's important to understand that you will essentially be taking on an additional mortgage, which comes with monthly payments. Your monthly payments could also be higher than you anticipate.

Lenders that provide borrowers with a home equity line of credit typically charge high interest rates to account for increased risk. If you default on your mortgage, the initial mortgage you obtained on your home will be paid out first, which means that it's possible the second lender won't receive any payments to account for their losses.

 

Types of Mortgage Loans

 

There are many different types of loans that you could obtain when attempting to purchase a home. Along with a conventional loan, it's possible to seek a fixed-rate mortgage or adjustable-rate mortgage, both of which center around the interest rates that you'll be paying.

You could also look into applying for a non-conforming loan, the primary of which include government-backed loans and jumbo loans. The main government-backed loans available to you include FHA loans, USDA loans, and VA loans. These loans are backed by different agencies within the U.S. government. For instance, VA loans are backed by the U.S. Department of Veterans Affairs.

Keep in mind that there are special requirements if you attempt to apply for a government-backed loan. As for jumbo loans, you can obtain this type of loan if you're buying a more expensive property with a loan amount that's above $550,000.

 

How to Get Rid of PMI Later On

 

Before you obtain private mortgage insurance, it's important to understand that this insurance isn't meant to last forever. Right after you purchase a home, some of your monthly mortgage payments will go towards the principal of your loan, which is the original loan amount. When you put money towards paying off the loan principal, you will be able to build equity in your home, which is essentially the difference between the value of your home and the amount that you currently owe.

Once you've built up 20% home equity, you can send a request to your lender to make sure that your private mortgage insurance is canceled. In the event that you make significant improvements to your home, you may be able to have your insurance canceled because of how much the improvements have increased the value of your home. If you opt for this method, Fannie Mae will only cancel your PMI with 25% equity. On the other hand, Freddie Mac has a 20% requirement. You can also stop paying for PMI by refinancing your home, which gives you the opportunity to qualify for a lower interest rate.

Private mortgage insurance is a frustrating necessity for most lenders. However, it can be avoided if you pay 20% of the loan or build up enough equity to have the insurance canceled. When you're first shopping for a mortgage loan, make sure that you ask your lender how they handle private mortgage insurance.

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