Private Mortgage Insurance (PMI) is a type of insurance that lenders require borrowers to purchase when they make a down payment that is less than 20% of the home’s purchase price. PMI protects the lender in case the borrower defaults on the loan. While PMI allows borrowers to buy a home with a smaller down payment, it also adds to the monthly mortgage cost. Understanding the role of PMI and how to avoid it can save you money in the long run. Here’s what you need to know.
1. What Is Private Mortgage Insurance (PMI)?
Private Mortgage Insurance (PMI) is an insurance policy that protects the lender—not the borrower—in the event that the borrower stops making payments on their mortgage. PMI is typically required for conventional loans where the borrower’s down payment is less than 20% of the home’s purchase price.
How PMI Works:
- Monthly Premiums: PMI is usually paid as a monthly premium added to your mortgage payment. The cost of PMI can range from 0.3% to 1.5% of the original loan amount per year, depending on your credit score, loan-to-value (LTV) ratio, and the size of the down payment.
- Automatic Termination: PMI is automatically canceled once your loan balance reaches 78% of the original home value (meaning you have 22% equity) if you are current on your payments.
- Request for Cancellation: You can request to have PMI canceled once you have 20% equity in your home, based on the original value or an appraisal, and if your mortgage is in good standing.
2. Why Lenders Require PMI
Lenders require PMI because loans with smaller down payments are considered riskier. If the borrower defaults on the loan, the lender is at greater risk of losing money because there’s less equity in the property to cover the outstanding loan balance. PMI mitigates this risk by providing the lender with insurance coverage that can offset their losses in the event of a default.
3. The Cost of PMI
The cost of PMI can vary based on several factors:
- Loan Amount: The larger the loan, the higher the PMI cost.
- Loan-to-Value (LTV) Ratio: The LTV ratio is the percentage of the home’s value that you’re borrowing. A higher LTV ratio (meaning a smaller down payment) typically results in higher PMI premiums.
- Credit Score: Borrowers with higher credit scores are generally charged lower PMI rates because they pose less risk to lenders.
- Type of Loan: The specific terms of your loan, including whether it’s fixed-rate or adjustable-rate, can also affect PMI costs.
For example, if you have a $200,000 loan with a PMI rate of 0.75%, your annual PMI cost would be $1,500, or $125 per month.
4. How to Avoid PMI
Avoiding PMI can save you money on your monthly mortgage payment. Here are several strategies to avoid or minimize PMI:
a. Make a 20% Down Payment
- Standard Method: The most straightforward way to avoid PMI is to make a down payment of 20% or more when purchasing your home. This eliminates the need for PMI altogether, as you’ll have sufficient equity in the property from the start.
b. Consider a Piggyback Loan
- 80-10-10 Loan: A piggyback loan involves taking out a second mortgage to cover part of the down payment, usually in an 80-10-10 structure. This means you take out a first mortgage for 80% of the home’s value, a second mortgage for 10%, and make a 10% down payment. The second mortgage typically has a higher interest rate, but it can help you avoid PMI.
c. Opt for Lender-Paid Mortgage Insurance (LPMI)
- Lender-Paid PMI: With LPMI, the lender pays the PMI premium upfront, but you’ll pay a higher interest rate on your mortgage in return. While this can increase your overall loan cost, it eliminates the monthly PMI payment. Compare the total cost over the life of the loan to see if this option makes sense for you.
d. Use a VA Loan
- Veterans Affairs (VA) Loans: If you’re a qualified veteran, active-duty service member, or eligible surviving spouse, you may qualify for a VA loan, which doesn’t require PMI, regardless of your down payment amount.
e. Apply for a Piggyback Loan
- Piggyback Loan (80-10-10): A piggyback loan involves taking out a second mortgage to cover part of the down payment, typically 10%, while making a 10% down payment from your funds. This allows you to avoid PMI by keeping the primary mortgage at 80% of the home’s value.
f. Refinance to Remove PMI
- Refinancing: If you already have PMI and have built up sufficient equity in your home, you may be able to refinance your mortgage to eliminate PMI. If your home’s value has increased significantly, refinancing could help you reach the 20% equity threshold and remove PMI.
g. Pay Down Your Mortgage Faster
- Extra Payments: Making extra payments toward your mortgage principal can help you build equity faster. Once you reach 20% equity, you can request that the lender cancel PMI. Be sure to notify your lender when you’ve reached this milestone, as they won’t automatically cancel PMI until you’ve reached 22% equity.
5. When PMI May Be Unavoidable
In some cases, avoiding PMI may not be feasible, especially if you’re unable to make a large down payment. In these situations, it’s important to weigh the cost of PMI against the benefits of buying a home sooner rather than later.
- Weigh the Costs: While PMI adds to your monthly payment, it can still be worth it if you’re able to purchase a home and start building equity sooner. Compare the cost of PMI with the potential appreciation of the home’s value and the tax benefits of homeownership.
- Budget for PMI: If you know you’ll need to pay PMI, factor this cost into your homebuying budget. Understanding the additional cost upfront can help you avoid financial surprises later on.
6. How to Remove PMI Once You Have It
If you have PMI, there are ways to remove it once you’ve built up sufficient equity in your home.
- Automatic Cancellation: PMI is automatically canceled once your mortgage balance reaches 78% of the home’s original value, provided you’re current on your payments.
- Request Cancellation: Once your mortgage balance reaches 80% of the home’s original value, you can request that your lender cancel PMI. You may need to provide proof of the home’s current value through an appraisal.
- Refinance Your Mortgage: If your home’s value has increased, refinancing can help you reach the 20% equity threshold and eliminate PMI.
Conclusion
Private Mortgage Insurance (PMI) is an additional cost that can increase your monthly mortgage payment, but it also enables you to buy a home with a smaller down payment. While PMI is often unavoidable for buyers with less than 20% down, there are strategies to avoid or minimize it, such as making a larger down payment, choosing a piggyback loan, or refinancing once you’ve built enough equity. Understanding how PMI works and how to manage it can help you make informed decisions and save money on your mortgage.