An Introduction to Private Mortgage Insurance (PMI)
What is Private Mortgage Insurance and How to Avoid It
When buying a home, there are several "hidden" costs you may need to watch out for. Private mortgage insurance is one of them.
Private mortgage insurance, or PMI, is insurance that lenders require borrowers to have when they get a mortgage and don’t have enough equity in the home. For many buyers seeking a mortgage, avoiding the added expense of PMI means coming up with a 20% down payment when buying a home. Unfortunately, it's not always easy for new home buyers to come up with that kind of cash, but there are a few other options to avoid paying PMI premiums.
What is Private Mortgage Insurance (PMI)?
While at first private mortgage insurance may seem like just part of your mortgage payment, it is actually a very important and separate risk-management tool for lenders. This type of borrower-paid mortgage insurance protects the lenders against major loss in case the borrower defaults on the loan. An active PMI contract allows the lender to recover the money they loaned to the homebuyer even if the home is no longer worth enough to pay off the balance.
It's standard practice for mortgage lenders to require private mortgage insurance for loans with a loan-to-value (LTV) percentage greater than 80%, which generally occurs when the borrower puts down less than 20% of the home's value at purchase. In this sense, PMI can also be a useful tool for borrowers. Agreeing to pay PMI premiums allows a homebuyer to purchase a home without coming up with the full 20% down and instead make a smaller down payment.
While from a financial planning standpoint, it's a good idea to have money to put down on a new home purchase, it can also take years of saving just to get to that 20% number. With PMI in place, homebuyers are able to put less money down and purchase the home sooner while the mortgage lender is protected from what could be considered a more risky loan. The tradeoff for the borrower is an increased monthly mortgage payment, since it includes the cost of the PMI premium.
In addition to a monthly premium, there's also an upfront PMI premium that's due at the beginning of the loan. This amount may be paid with your closing costs or rolled into the loan itself.
How to Eliminate PMI
Traditionally, borrowers are only required to keep the private mortgage insurance as long as the loan-to-value percentage is less than 80%, meaning that they only need to pay the insurance premiums until they've acquired enough equity in the home so that the lender no longer considers the mortgage "high-risk."
For borrowers who are currently paying PMI premiums as a part of their monthly mortgage payments, there are two ways the PMI portion of the payment can be eliminated with a cancellation of the policy:
- Borrower-prompted PMI cancellation
- Automatic lender PMI cancellation
Both are determined by the borrower's accumulated equity. A borrower has the right to request cancellation or termination of the PMI policy when he or she has paid down the mortgage balance to the point that it equals 80% of the original purchase price or appraised value of your home at the time the loan was obtained, whichever is less. This route requires the borrower to actively manage the mortgage and take action when PMI is no longer required.
The second option is automatic cancellation of the PMI policy by the lender. But, there’s a catch. A lender won’t automatically stop PMI payments until you've accumulated 22% equity in the home rather than 20%. While a borrower has the right to cancel PMI at the 20% equity mark, a lender won’t automatically cancel the policy for another 2 percent meaning that the borrower will be spending money on unnecessary PMI premiums as their monthly mortgage payments help them acquire that additional 2% in equity.
Simply put, borrowers are wasting money if they don’t cancel their PMI after hitting the 20% equity mark.
The Cost of PMI
The cost of private mortgage insurance varies slightly from policy to policy, but a borrower can generally expect to pay roughly $40-$50 each month per $100,000 borrowed, or 0.25% to 2% of the mortgage balance per year. So, for a $200,000 loan a borrower might pay nearly $100/month on PMI premiums, or over $1,000 each year.
When you think about it, that amount really starts to add up. Obviously, the larger the mortgage and the smaller the down payment in terms of percentage, the larger the PMI payment. If a borrower ends up paying PMI premiums for many years, it can literally cost thousands of dollars. As such, the added cost of PMI should be factored into your decision when determining how much house you can afford and how much of a down payment you'd like to offer.