How Lender Paid Mortgage Insurance (LPMI) Works
Lenders require you to use mortgage insurance whenever your down payment is less than 20 percent of your home’s value. That insurance protects the lender in case you fail to pay the mortgage. While it’s unfortunate to have to pay mortgage insurance, the upside is that you can buy a home without plunking down 20 percent—which might require several more years’ worth of saving.
Typically, you (the borrower) pay a monthly premium for private mortgage insurance (PMI). That’s an extra cost each month, and it takes a bite out of your budget. However, some lenders offer lender paid mortgage insurance (LPMI), which allows you to reduce or avoid that extra monthly payment.
Whether or not it’s a good idea to buy with less than 20 percent down is debatable, and is a topic for another article.
How LPMI Works
LPMI is mortgage insurance that your lender arranges. You pay for the coverage in one of two ways:
- A one-time payment at the beginning of your loan (a “lump-sum” payment)
- A higher interest rate on your loan, resulting in higher monthly mortgage payments every month, for the life of your loan.
The lump-sum approach is less common than an adjustment to your mortgage rate.
Unfortunately, the term LPMI is not accurate because the lender doesn’t really pay for insurance—you do. Always remember (especially with financial transactions) that nobody pays costs for you unless they get something in return. To use LPMI, you just change the structure of insurance premium payments so that you don’t pay a separate charge every month.
If you pay a lump sum, your lender will determine the amount that they think will cover their costs. Then, they buy mortgage insurance with that money. In this case, you basically prepay for coverage.
If you pay over time, the lender adjusts your mortgage rate to cover the costs of insurance. Because a higher mortgage rate means higher monthly payments (see How to Calculate Loans) you’ll end up paying more each month if you go for LPMI. That higher payment should be less than you’d pay if you used a separate PMI charge every month, but there’s no way to “cancel” the extra cost as you pay down your loan.
Pros and Cons of LPMI
LPMI is not for everybody. In fact, not everybody will qualify for a loan with LPMI. Typically you need to have good credit for LPMI to be an option, and it only makes sense in certain situations.
Short-term loans: LPMI is most attractive for shorter-term loans. If you plan to get a 30-year loan and make payments for decades, you might be better off with a separate PMI policy. Why? Again, most LPMI loans use an adjusted (higher) mortgage interest rate, as opposed to a lump-sum payment up front. That mortgage rate will never change, so you’ll have to pay off the loan completely to get rid of the LPMI “premium.” You can do this either by paying the loan off out of your own savings (easier said than done), refinancing the loan, or selling the home and paying off the debt.
For comparison, look at a standalone PMI policy, which you can cancel once you build sufficient equity in your home. After canceling, you benefit from a lower interest rate—and no more PMI payments—for the remainder of your loan’s life.
High-income earners: For those who can get approved for LPMI, it is most attractive for borrowers with high incomes. Those individuals and families may enjoy a greater tax deduction because of the higher interest rate (assuming they deduct home mortgage interest costs). People with lower incomes, on the other hand, might be able to deduct stand-alone PMI, so LPMI would not bring any additional tax benefits. Of course, you should always talk with your tax preparer about potential deductions—and even how best to structure your mortgage loan.
These rules change periodically, so check with an expert for updates before you decide on anything (and be prepared for changes after you make your decision).
High LTV: If your loan to value ratio (LTV) is close to 80 percent, LPMI is probably not your best option unless you plan to get rid of the loan soon (by refinancing or prepaying). Near 80 percent, you're almost done with mortgage insurance altogether. If you use a separate mortgage insurance policy instead, you can make a separate payment each month. You’ll be able to cancel the insurance relatively soon, and you won’t be stuck with a higher interest rate. Remember that there are several ways to get above 80 percent LTV:
- By making payments, you increase your home equity, and you reduce your LTV.
- If your home’s value increases due to a strong housing market or home improvements, your LTV improves.
Alternatives to LPMI
If LPMI doesn’t sound like the perfect fit for you, you can try several different approaches.
Bigger down payment: By putting down at least 20 percent, you eliminate the need to pay PMI. However, many buyers don’t have that option.
Buy your own PMI: You can always pay for your own PMI (sometimes called borrower paid mortgage insurance or BPMI) every month. You’ve already seen a few examples of situations where plain-old PMI is better than LPMI above.
Piggyback: You can also try a combination of loans to avoid PMI, although you need to review the numbers carefully. A piggyback strategy, also known as an 80/20 loan, is just one option. These loans are not as common as they used to be, but they’re available. A piggyback allows you to avoid mortgage insurance altogether, but your second mortgage will come with a higher interest rate. If you can pay off the second mortgage quickly, you’ll eventually enjoy having a low mortgage rate (which is not increased by LPMI) for years to come.
Low-down-payment loans: Several loan programs allow small down payments. For example, FHA loans are available with as little as 3.5 percent down. You have to pay for mortgage insurance, but those loans might be a better fit for some borrowers. VA loans allow for zero down, and they don’t require any mortgage insurance.