Private Mortgage Insurance (PMI)
Private Mortgage Insurance, or “PMI”, is a type of insurance charged on conventional mortgage loans. This insurance is essential for mortgages under a specific loan to value ratio and provides coverage for the lender when they give you a loan.
In this guide, we’ll look at who needs to pay PMI and why, while also discussing the ways that you can avoid this insurance.
What is Private Mortgage Insurance?
Private Mortgage Insurance protects the lender, not the borrower. It covers the lender in the event that you can no longer cover your monthly mortgage payment and is levied on conventional mortgages with a less than 20% down payment.
There are a couple of ways that you can pay for PMI, including:
- Added to Loan Balance: Your mortgage insurance premiums are bundled with your monthly mortgage payments.
- Upfront: You cover the full cost upfront.
In most cases, you will make an initial upfront payment and then pay the rest of the money in monthly installments, along with the loan payments and taxes.
You can discuss your options with the lender. All details of these premiums are included on your loan estimate, which outlines the details of your loan and shows you where your monthly payments go.
Who Needs Private Mortgage Insurance?
PMI is used to offset the increased risk that a lender faces when the borrower has a small down payment. It can increase your chances of acquiring a mortgage and is required for government-backed mortgages such as an FHA loan or a USDA loan.
This insurance covers the lender, not the borrower, but if you don’t have the money to pay for a large down payment it can help you secure a deal. The lender will arrange insurance via a private insurance provider (such as Mortgage Guaranty Insurance) and you will be given a full cost breakdown before signing on the dotted line.
How Much Does It Cost?
PMI is calculated as a fixed percentage (often between 0.50% and 2.25%) of the original loan amount and it is charged annually. This annual fee is then broken down into monthly payments, with the lender holding onto these payments and releasing them in annual installments. The same happens with taxes, while the remainder of the monthly mortgage total consists of interest (the lender’s charge) and principal (the original loan amount).
As an example, let’s assume the following:
- Purchase Price = $200,000
- Down Payment = $20,000
- Principal and Interest = $870
- Taxes = $135
- Private Mortgage Insurance = $75
In this example, your total mortgage payment will be $1,082, assuming an interest rate of 4.1% and a term of 30 years. However, this also assumes a low PMI rate of 0.5% and doesn’t factor homeowner’s insurance premiums into the equation.
You may be charged a higher interest rate; you may have a smaller down payment. In any case, it’s worth doing your sums in advance and looking at your options. For instance, you may determine that it’s best to wait 6 months and use that time to improve your credit score and save an extra $10,000. You may lose the house you wanted or be forced to pay more than the purchase price, but you’ll also be offered better mortgage rates and won’t need to cover PMI.
With an extra $10,000 to go towards the down payment and a mortgage rate that’s just 0.5% lower, your mortgage payments could look like this:
- Principal and interest = $720
- Taxes = $135
- Total = $855
That’s a saving of over $200 a month and tens of thousands over the term of the mortgage loan. If you keep the payment amount the same and focus instead on reducing the term, you could save even more over the long-haul.
What are the Pros and Cons of Private Mortgage Insurance?
The only benefit of PMI is that it allows you to acquire a conventional loan when you can’t afford a 20% down payment. However, there are several downsides that you need to consider before you rush in and start paying extra for that dream home you have your eye on:
- Cost: As discussed above, PMI can greatly increase the cost of a conventional loan, resulting in up to $100 extra per month and costing you thousands before you acquire the necessary equity.
- You’re Not Covered: Unlike homeowner’s insurance, PMI doesn’t provide any coverage to you and your home, and unlike life insurance, it won’t provide any benefits to your heirs. It’s all about the lender.
- Not Deductible: There was a time when PMI was tax-deductible, but that’s no longer the case following a rule change in 2018.
- Wasted Money: PMI is wasted money as it doesn’t go towards building your net worth. From an investment point of view, you’re better off biding your time and saving towards a bigger down payment, essentially buying more equity at the start of the loan.
- Endless Payments: While most lenders will stop PMI payments when you attain 20% equity, others will keep them going. Check your mortgage documents closely to make sure you’re not being stung with years of needless payments.
How Private Mortgage Insurance Works
Mortgage loans with a small down payment are considered high risk as the lender stands to lose a lot of money if you default. They can repossess the house, but repossession is neither quick nor cheap and costs close to $50,000 on average, so they’re keen to avoid it. By providing them with a 20% down payment you’re helping to negate some of that risk and if you don’t have the money for that 20%, PMI can help.
When your loan-to-value ratio reaches 80%, PMI payments should stop. However, this isn’t always the case. You can find further details of the PMI cancellation criteria in your mortgage documents.
Differences Between PMI and Mortgage Protection Insurance
PMI is designed to cover the lender when the mortgage has a loan-to-value ratio of less than 80%; mortgage projection insurance covers the borrower when they can no longer afford to meet their mortgage payment.
Many homeowners get these two insurances confused, believing that PMI essentially provides the same benefits as mortgage protection insurance and will cover them if they can’t make those payments, but this simply isn’t the case. If you can’t make your mortgage payment every month then you run the risk of defaulting, at which point your home may be repossessed and the lender will seek to recover costs from the insurance company.
How Does Mortgage Protection Insurance Work?
Mortgage protection insurance is voluntary and can be taken by any borrower for any type of mortgage. It works in a similar way to a life insurance policy, in that it is designed to provide you with financial cover in the event of a worst-case scenario, such as unemployment. Also, like life insurance, you will receive better rates and lower premiums if you are young and in good health.
The exact terms and costs will depend on the provider and the policy, but if you have a strong credit score, a good financial history, and a stable job, you should be classed as low risk. Shop around, check the terms, and read the small print before you sign anything.
Who Needs Mortgage Protection Insurance?
No one needs mortgage protection insurance, just like no one needs life insurance. Some people consider insurance like this to be a gamble and to an extent, they’re right, as the insurance company always walks away with a profit. However, if you have a large mortgage to cover and want some peace of mind, it’s worth considering.
Of course, as with health insurance and life insurance, the more you need it the more expensive it will be. If there is any suggestion that you could lose your job or you have an extensive history of unemployment, you may be refused or offered very high rates.
It’s worth thinking about the worst-case scenario to see just how beneficial mortgage protection insurance would be. Ask yourself what would happen if you lost your job tomorrow—could you get a loan to tide you over, do you have savings, can your partner cover the payments?
If your answers are in the negative, it’s worth getting a quote. Just remember to factor the costs of that quote into your monthly budget when calculating your mortgage payments, mortgage insurance premiums, and taxes.
How to Avoid Private Mortgage Insurance
The best way to avoid PMI is to save more money, even if it takes you a couple of years to do so. You should never take out an additional loan or line of credit just to cover the costs and you should also be wary of piggyback mortgages.
A piggyback mortgage requires that you cover part of the down payment and take out a loan for the rest. But there are many strings attached, including the fact that many piggyback mortgages use adjustable rates and have substantial balloon payments, hurting your finances and your credit score.
Should you Pay Private Mortgage Insurance?
If you want a conventional loan and don’t have a 20% down payment then you don’t really have much choice. As mentioned above, you can get a loan to cover the additional down payment, but that loan will likely cost you more than PMI. It will also give you an extra debt to worry about, one that will increase your monthly loan payments, impact your debt-to-income ratio, and reduce your credit score, potentially preventing you from getting a mortgage in the first place.
It’s always best to avoid PMI if you can, so make sure you exhaust the following options first:
It’s easier said than done, but if you create a detailed budget, tighten your belt and work hard on saving every cent, you could have the additional funds in a year or two. It can be deflating to wait that long, especially if you have your heart set on moving, but it will benefit you in the long term.
Just remember to save more than you need for the down payment as that’s not the only cost to cover. You also have to consider closing costs, moving companies, legal fees, and more.
The average American household contains thousands of dollars’ worth of junk that just gathers dust, from designer clothes to DVDs, games consoles, computers, and more. Have a clear out, sell the things you don’t need, and use the money to put towards your home loan.
At the very least you can put it to one side you help you with a future payment.
Build an Emergency Fund
It always helps to have an emergency fund for those months when money is tight and you need a helping hand. And if those days don’t come, you can use that fund to increase your monthly payment, thus reducing the total interest and shortening the mortgage term.
Ask family and friends for a small loan to cover the additional down payment. You can offer to repay the loan in its entirety because the amount you save by not paying PMI will ensure you have at least $1,000 extra in your account every year.
Be mindful of asking friends for a loan, however. It’s a lot of money to ask from someone who isn’t a parent or grandparent and it puts them in an awkward position.
Take Your Time
Finally, regardless of what option you choose, remember to take your time, think it through, and calculate every penny spent now and in the future. Don’t rush in as you’re making a decision that could impact your life for decades to come.
Remember that even the smallest interest rate reduction or the slightly monthly payment saving could reduce your total loan balance by thousands of dollars. And the more equity you have to begin with, the better that financial position will be, as you can then think about home equity loans, home equity lines of credit, and other finance options that use your equity as collateral.