Private Mortgage Insurance, one of the most important financial decisions a homebuyer will face is how to finance the purchase. Mortgages are the most common means of financing a home, but for many buyers, coming up with a 20% down payment can be a significant hurdle. In such cases, lenders typically require Private Mortgage Insurance (PMI) to protect their investment. This article explores what PMI is, why it is necessary, and how homeowners can avoid it. We will also discuss the types of PMI, its costs, and the steps that can be taken to eliminate it.
1. What is Private Mortgage Insurance (PMI)?
Private Mortgage Insurance (PMI) is a type of insurance policy that protects lenders in the event that a borrower defaults on their mortgage. PMI is typically required on conventional loans when the borrower is unable to provide a down payment of at least 20% of the home’s purchase price. This is because a smaller down payment means the borrower has less equity in the home, which increases the risk for the lender.
For example, if a borrower puts down 10% on a home and takes out a mortgage for 90% of the home’s value, the lender assumes more risk than if the borrower had put down 20%. PMI is designed to mitigate that risk by offering financial protection to the lender if the borrower defaults.
While PMI protects the lender, it does not provide any protection for the borrower. The borrower pays for the insurance, but it does not cover any of their costs in the event of default.
2. Why is PMI Necessary?
PMI is a tool used by lenders to manage risk. When a borrower makes a smaller down payment, they have less financial “skin in the game,” which means they may be more likely to default on the loan if they encounter financial difficulties. PMI mitigates the risk for the lender by offering a safety net. If the borrower defaults, the PMI coverage helps the lender recover some of the losses.
From the borrower’s perspective, PMI enables them to purchase a home with a smaller down payment, typically 5% to 15%. Without PMI, a lender would likely not approve a mortgage with such a small down payment due to the higher risk involved. Therefore, PMI helps facilitate homeownership for buyers who cannot afford a large down payment but still want to purchase a home.
3. How Does PMI Work?
PMI is a monthly expense that is typically added to the borrower’s mortgage payment. The lender or servicer will collect the PMI premiums along with the regular mortgage payments. The premiums are calculated based on a percentage of the loan amount, typically ranging from 0.3% to 1.5% annually, depending on factors such as the size of the down payment, the loan amount, and the borrower’s credit score.
PMI payments can either be paid monthly, in a lump sum at closing, or as a combination of both. The most common form is the monthly premium, which is included in the borrower’s total mortgage payment. In this case, the borrower will make one payment each month that includes principal, interest, taxes, insurance, and PMI.
Here’s an example of how PMI works in a typical mortgage scenario:
- Loan amount: $200,000
- PMI rate: 0.5%
- Annual PMI premium: $1,000
- Monthly PMI premium: $83.33
The borrower’s total monthly mortgage payment would include $83.33 for PMI, in addition to principal, interest, taxes, and homeowner’s insurance.
4. Types of PMI
There are several types of PMI policies available to borrowers. The type of PMI required depends on the loan terms and the lender’s policies. The main types of PMI are:
a. Monthly PMI
This is the most common type of PMI. With monthly PMI, the borrower pays a premium every month along with their mortgage payment. The premium is typically calculated as a percentage of the loan amount, as mentioned earlier. Monthly PMI is required for most borrowers who make a down payment of less than 20% on a conventional loan.
b. Single Premium PMI
With single premium PMI, the borrower pays a lump sum upfront at closing. This payment covers the cost of PMI for the life of the loan. Although the upfront cost may be higher, borrowers with single premium PMI do not have to worry about monthly premiums. This type of PMI can be advantageous for those who have the financial capacity to pay a large amount upfront.
c. Split Premium PMI
Split premium PMI is a combination of monthly and upfront premiums. In this scenario, the borrower makes a smaller upfront payment at closing and then pays monthly premiums for the duration of the loan. This type of PMI offers a balance between the two other options.
d. Lender-Paid Mortgage Insurance (LPMI)
In some cases, lenders may offer Lender-Paid Mortgage Insurance (LPMI), in which the lender pays for the PMI premium. While this option eliminates the need for the borrower to pay monthly premiums, it generally comes with a higher interest rate. The higher interest rate over the life of the loan often results in greater overall costs than paying monthly PMI premiums.
5. When Is PMI Required?
PMI is typically required in the following situations:
a. Conventional Loans with Less Than 20% Down Payment
For most conventional loans, PMI is required if the borrower makes a down payment of less than 20% of the home’s purchase price. The exact percentage required for PMI depends on the loan size, the borrower’s credit score, and the down payment. For example, if a borrower makes a 10% down payment, PMI is almost always required. If the borrower is able to put down 15%, PMI may still be required but could be lower.
b. High Loan-to-Value (LTV) Ratios
Lenders generally require PMI when the loan-to-value (LTV) ratio is greater than 80%. The LTV ratio is the ratio of the loan amount to the appraised value of the property. If the LTV ratio is greater than 80%, the borrower has less equity in the home, and the lender faces higher risk. PMI is a way for the lender to offset that risk.
c. Riskier Borrowers
In some cases, even if the borrower’s down payment is greater than 20%, PMI may still be required if the borrower is considered a higher-risk borrower. This could be due to a low credit score, a high debt-to-income ratio, or other risk factors that make the lender more cautious.
6. How Much Does PMI Cost?
The cost of PMI varies depending on several factors, including the loan amount, the size of the down payment, the borrower’s credit score, and the type of PMI selected. In general, PMI premiums range from 0.3% to 1.5% of the original loan amount per year.
Here is a breakdown of PMI costs based on different loan amounts:
- For a $200,000 loan with a 0.5% PMI rate, the annual premium would be $1,000, or $83.33 per month.
- For a $300,000 loan with a 1% PMI rate, the annual premium would be $3,000, or $250 per month.
The higher the loan amount and the smaller the down payment, the higher the PMI premium will be. Borrowers with better credit scores may pay lower PMI rates than those with lower credit scores.
7. How to Avoid PMI
While PMI is necessary for many homebuyers who cannot afford a 20% down payment, there are several ways to avoid it. Here are some strategies to consider:
a. Make a 20% Down Payment
The most straightforward way to avoid PMI is to make a down payment of at least 20%. This means you would need to save for a larger down payment, but it eliminates the need for PMI altogether.
b. Use a Piggyback Loan
A piggyback loan, also known as a second mortgage, is a strategy where the borrower takes out two loans: one for 80% of the home’s value (the primary mortgage) and another for 10% or 15% (the piggyback loan). This allows the borrower to avoid PMI by putting down 20% or more on the home without needing to use a single large mortgage. However, piggyback loans may come with higher interest rates and additional fees.
c. Look for Lender-Paid Mortgage Insurance (LPMI)
Some lenders offer Lender-Paid Mortgage Insurance (LPMI), where the lender pays the PMI premium. While this can eliminate monthly PMI payments, it often results in a higher interest rate. Borrowers must weigh the benefits of LPMI against the increased interest costs over the life of the loan.
d. Refinance Your Loan
Once you reach 20% equity in your home, you can refinance your loan to remove PMI. This usually requires getting a new appraisal and securing a new loan at favorable terms. If the value of your home has appreciated and you have paid down enough of the principal, refinancing may be a good option to eliminate PMI.
