5 Types of Private Mortgage Insurance (PMI)
If you’re making a down payment of less than 20% on a home, it’s essential to understand your options for private mortgage insurance (PMI). Some people simply cannot afford a down payment in the amount of 20%. Others may elect to put down a smaller down payment in favor of having more cash on hand for repairs, remodeling, furnishings, and emergencies.
What Is Private Mortgage Insurance (PMI)?
Private mortgage insurance (PMI) is a type of insurance that a borrower might be required to buy as a condition of a conventional mortgage loan. Most lenders require PMI when a homebuyer makes a down payment of less than 20% of the home’s purchase price.
When a borrower makes a down payment of less than 20% of the property’s value, the mortgage’s loan-to-value (LTV) ratio is over 80% (the higher the LTV ratio, the higher the risk profile of the mortgage for the lender).
Unlike most types of insurance, the policy protects the lender’s investment in the home, not the individual purchasing the insurance (the borrower). However, PMI makes it possible for some people to become homeowners sooner. For individuals who elect to put down between 5% to 19.99% of the residence’s cost, PMI allows them the possibility of obtaining financing.
However, it comes with additional monthly costs. Borrowers must pay their PMI until they have accumulated enough equity in the home that the lender no longer considers them high-risk.
PMI costs can range from 0.25% to 2% of your loan balance per year, depending on the size of the down payment and mortgage, the loan term, and the borrower’s credit score. The greater your risk factors, the higher the rate you’ll pay. And because PMI is a percentage of the mortgage amount, the more you borrow, the more PMI you’ll pay. There are several major PMI companies in the United States. They charge similar rates, which are adjusted annually.
While PMI is an added expense, so is continuing to spend money on rent and possibly missing out on market appreciation as you wait to save up a larger down payment. However, there’s no guarantee you’ll come out ahead buying a home later rather than sooner, so the value of paying PMI is worth considering. Some potential homeowners may need to consider Federal Housing Administration (FHA) mortgage insurance. However, that only applies if you qualify for a Federal Housing Administration loan (FHA loan).
Private Mortgage Insurance (PMI) Coverage
First, you should understand how PMI works. For example, suppose you put down 10% and get a loan for the remaining 90% of the property’s value—$20,000 down and a $180,000 loan. With mortgage insurance, the lender’s losses are limited if the lender has to foreclose on your mortgage. That could happen if you lose your job and can’t make your payments for several months.
The mortgage insurance company covers a certain percentage of the lender’s loss. For our example, let’s say that percentage is 25%. So if you still owed 85% ($170,000) of your home’s $200,000 purchase price at the time you were foreclosed on, instead of losing the full $170,000, the lender would only lose 75% of $170,000, or $127,500 on the home’s principal. PMI would cover the other 25%, or $42,500. It would also cover 25% of the delinquent interest you had accrued and 25% of the lender’s foreclosure costs.
If PMI protects the lender, you may be wondering why the borrower has to pay for it. Essentially, the borrower is compensating the lender for taking on the higher risk of lending to you—versus lending to someone willing to put down a larger down payment.
How Long Do You Have to Buy Private Mortgage Insurance (PMI)?
Borrowers can request that monthly mortgage insurance payments be eliminated once the loan-to-value ratio drops below 80%. Once the mortgage’s LTV ratio falls to 78%, the lender must automatically cancel PMI as long as you’re current on your mortgage. That happens when your down payment, plus the loan principal you’ve paid off, equals 22% of the home’s purchase price. This cancellation is a requirement of the federal Homeowners Protection Act, even if your home’s market value has gone down.