If you are like most people, you will buy a home by making a down payment and getting a mortgage loan for the balance. You may have accumulated a large amount to apply toward your down payment. Or you might have a minimal amount to invest. If that amount falls short of 20 percent of the home’s value and you are getting a conventional loan — one not backed by the federal government — be aware that you will most likely have to pay for private mortgage insurance.
Private mortgage insurance (PMI) is a policy that protects the lender against financial loss if you default on your loan. Experience tells them that the more money you put into a home, the lower the risk. You are far less likely to walk away from your loan when you have a substantial amount of cash to lose in addition to your home. On the other hand, the less invested you are financially, the higher the risk. Because lenders seek to minimize risk, they want either a substantial down payment, traditionally 20 percent, or insurance that will pay them the principal amount if they foreclose.
As you can see, lenders benefit from PMI. But borrowers pay for it. The rationale is that you are paying for coverage that enables the lender to grant what would otherwise be a riskier loan. How much can you expect to pay? Premiums vary. Factors that affect cost include the type of mortgage and the amount of your down payment. Generally, you can expect PMI to be about 0.5 percent of the loan amount. Here is an example using that percentage assumption. Let’s say the home value is $200,000 and you make a 10 percent down payment. PMI would add approximately $75 per month onto your mortgage payment.
So how can you avoid paying PMI even when your down payment is less than 20 percent? Lenders offer other options for which they will determine your eligibility. Some lenders waive their PMI requirement if you pay a higher interest rate on the loan. What they do is pay the premium for you and build the cost into the interest rate. Another option is called a “piggyback” loan. Under this arrangement, you have two loans – one for 80 percent of the home’s value and another for the balance remaining after your down payment. You might also ask if the seller is willing to carry the second mortgage. No matter which option you consider, do so in light of your personal financial circumstances. Also, when comparing the cost of each option against PMI, remember that mortgage interest is tax deductible and PMI is not.
If you are in the process of getting a loan and PMI is unavoidable, or if you already own your home and have been paying PMI for a while, don’t despair. It does have an end. When you have at least 20 percent equity in your home (home value minus loan balance), you can ask to have PMI cancelled. In order for that to happen you must have a good payment history, current payments, and no liens against your home. Some loans also have a minimum wait time, typically two years, before PMI can be eliminated. Also, when you make your request, expect your lender to ask for proof of the home’s value in the form of an appraisal. They may even ask you to pay for that appraisal.
Even if you don’t request cancellation of PMI, the Homeowner’s Protection Act of 1998 calls for automatic termination of PMI if the following conditions are met:
- Your loan to value ratio must be 78 percent or lower (22 percent equity or more)
- Your loan must be covered by the Act. Federal Home Administration (FHA) and Veterans Administration (VA) loans are not covered. In addition, there are different requirements for loans that are classified as high-risk.
- You must be current on your mortgage payments.
PMI costs can add up quickly. If you are already paying, keep close track of the equity in your home and request cancellation as soon at the 20 percent marks comes around. Pay only as long as you absolutely have to. If you are in the process of getting a loan, do your homework. Explore available options with your mortgage lender and ask them to fully explain all conditions that apply to PMI. That way you will be better prepared to select the loan option that is right for you.