Understanding Private Mortgage Insurance
If you’re considering buying a home, you’ve probably heard or read the term PMI more times than you can count, especially if you plan to finance your property purchase. PMI is just one of the many acronyms you may hear in the home-buying process; and if you’re a first-time home buyer, you’re probably a little clueless about what PMI is and how it works. We’re here to help.
The Basics of Private Mortgage Insurance
What is PMI?
PMI stands for private mortgage insurance, and it’s a type of mortgage insurance you may be required to have if you get a traditional loan for your home’s purchase.
Let’s break this down as simply as we can. First, what’s a mortgage? A mortgage is a type of loan you take on when purchasing a home, land, or other real estate. Whether you get a mortgage from a mortgage lender or a bank, you will be paying interest on that loan and may or may not be required to purchase private mortgage insurance. But unlike other insurance you purchase, PMI doesn’t protect you - PMI is meant to protect the lender if you stop making your loan payments.
You may have heard you must have 20% of a home’s purchase price to get a mortgage, but that’s not true. You may qualify for a mortgage regardless of your down payment, BUT you will probably be required to buy PMI if you don’t put at least 20% down. This requirement is there to protect the mortgage company should you default on your loan.
KEY TAKEAWAY: Private Mortgage Insurance (PMI) is insurance you will have to purchase if you get a mortgage loan on your house and don’t have at least 20% of the purchase price for a down payment.
How does PMI work?
Mortgage lenders are fronting the money for you to make a property purchase with the intention of making money off your loan thanks to the interest payments you will make. They lose money when you don’t make your mortgage payment, so to protect their investment, you may be required to get private mortgage insurance. This insures the mortgage lender will still get some payment should you default on your loan.
Of course, that is not an excuse to skip your mortgage payments. It’s never a good idea to not pay your mortgage. What happens if you don’t pay your mortgage? Usually after three months of non-payment, a foreclosure process will begin. You’re in an agreement to make the payments when you got your loan, and if you don’t hold up your end of the agreement, your property can be taken away from you due to foreclosure. If your property is foreclosed, your credit score could drastically drop, making it very difficult to get financing for future purchases. It can also take years to bring your credit score back up, so avoid this at all costs.
PMI helps offset the lender’s risk when loans have a high loan-to-value (LTV) ratio. A loan-to-value (LTV) ratio is industry speak for the loan amount divided by the value of the home. Loans with a high LTV ratio are considered higher risk than those with a lower LTV ratio, thus high LTV loans may receive a higher interest rate than a lower-risk one. The LTV ratio is a big component in underwriting a mortgage and may determine the eligibility of securing a mortgage or other property loans. The LTV ratio will also play a big part in the amount of your monthly payments.
How to avoid paying PMI – 5 options for not paying PMI
As mentioned above, having to pay PMI will increase your monthly payments, so if you’re not into paying money for things if you don’t have to, you’re probably wondering if there’s a way to avoid purchasing PMI.
Not all mortgages will require a purchase of PMI, and here are some ways you may be able to avoid it:
1. Pay cash for a home
If you’re paying for your property in cash, there’s no need to get a mortgage, thus no need for PMI. Of course, you should still get homeowners insurance, though!
It varies greatly by market, but 32% of home buyers paid cash for their homes in 2021, according to Zillow’s Consumer Housing Trends Report. Sellers love a cash offer, which can give buyers the upper hand in the current competitive housing market, but there are pros and cons to buying a house with cash so weigh your options, and consider speaking with a financial advisor who can look at your personal situation before going this route.
2. Have a down payment of 20% or more
If you have the funds, putting down at least 20% of the home’s purchase price is probably the simplest way to avoid having to purchase PMI. Let’s say you’re buying a home that costs $200,000. You would need to have $40,000 down, and you’d be getting a mortgage loan for $160,000. Having at least 20% gives the lender an LTV ratio of 80%. It shows you have skin in the game and are less likely to default on your mortgage loan.
3. Have a down payment of 10% and “piggyback” your mortgage
A “piggyback loan” is a unique way to structure a loan by providing a lower down payment and getting a second mortgage on top of your first mortgage.
A standard piggyback arrangement for a $200,000 home mortgage may look like this:
You provide a 10% down payment of $20,000 + You get a first mortgage of 80% for $160,000 + You get a second mortgage (or a home equity line of credit) of 10% for $20,000 = The $200,000 purchase price of the home.
This is often called an 80/10/10, and the second mortgage is typically from the same lender as the first mortgage. Since your first mortgage is supported by the 10% down payment plus the 10% second mortgage, this is a way you can avoid paying PMI.
4. Apply for a lender-paid mortgage insurance loan
If the lender is the beneficiary of PMI, it would only make sense for them to pay for the coverage, right? In a perfect world, maybe. But lenders don’t provide mortgage loans to be nice…they do it to make money. And paying for the PMI on your loan would cut into their profit; however, there are some lender-paid private mortgage insurance (LPMI) providers out there.
Do some research on LPMI lenders, but beware…. you’re probably going to be paying a higher interest rate throughout the life of the loan. Look at the big picture and see if an LPMI is worth it.
5. Apply for a no-PMI mortgage loan
There are some no-PMI mortgage programs out there, but you may have to meet certain qualifications. Here are some programs you should look into if you qualify and are trying to avoid paying PMI:
The Federal Housing Administration (FHA) has a program for those with a low down payment and/or low credit scores. Mortgage lenders are more likely to approve riskier loans when they have FHA backing.
Pros and cons to an FHA loan:
PROS:
- Avoids PMI
- Only requires 3.5% down payment
- Interest rates are typically fair
CONS:
- May require an upfront mortgage insurance premium (MIP) of 2.25% of the loan’s value
- There may be additional fees associated with an FHA loan
A VA home loan, backed by the U.S. Department of Veteran’s Affairs, is another way to bypass purchasing PMI if you’re a member of the United States military. You’ll need to provide a certificate of eligibility (COE) to your lender (as well as meet that lender’s credit and income loan requirements) to obtain the mortgage loan. You can request a COE online.
Who qualifies for a VA loan?
- Military active-duty service members who have served at least 90 continuous days
- Veterans
- National Guard Members
- Reserve members
- Surviving spouses of veterans
If you’re a veteran, national guard member or reserve member, your time-of-service qualifications are based on the time period when you served. If you don’t meet the minimum service requirements, you still may qualify for a VA home loan if you fall into certain categories for discharge. Your local Veterans Affairs office should be able to answer any questions you have about eligibility.
What are disadvantages to a VA home loan?
A VA home loan is probably one of the best options in the home mortgage industry. If you qualify, you will still want to consider some disadvantages to make sure you’re making the right decision for your personal situation.
Disadvantages to a VA home loan:
- You have less equity in your home
If you put nothing down on your home and it’s 100% financed, you have no equity; and depending on the housing market at the time, it may take a while to build equity.
- VA loans can be a complicated process
A VA loan may endure a little more paperwork and more strenuous appraisals. This could lengthen the contingency period and frustrate both the buyer and the seller.
- Stricter requirements
The property may have to meet certain requirements. You can’t use a VA loan to purchase a rental or investment property, and there are certain building codes that must be met.
KEY TAKEAWAY: To avoid paying PMI, you’d have to:
1. Pay cash for your house
2. Pay 20% of the purchase price as a down payment
3. Pay 10% down and “piggyback” a loan
4. Apply for a lender-paid mortgage insurance program
5. Qualify for a non-PMI program (like VA home loan or FHA loan)
Do you have to get PMI if you’re building a house?
Yes, even construction loans may require PMI if you don’t have 20% down. PMI on a construction loan is usually calculated the same way as a regular mortgage loan, so most of the same regulations apply. Don’t forget to get a homeowners insurance policy when you’re in the building process, too!
How much is PMI and how is it paid?
The cost of private mortgage insurance will vary based on a few factors like the amount of your loan, length of the term and your interest rate. According to Investopedia.com, PMI is around 0.5% to 2% of your loan balance each year.
Factors that determine the cost of PMI:
1. The size of the down payment
2. The amount of the mortgage loan
3. The loan term (usually a 15-year or 30-year term)
4. Loan interest rate
5. Borrower’s credit score
6. PMI interest rate (this will vary by lender)
For a ballpark figure of what your PMI payments may be, plug the figures into an online PMI calculator. But for the most accurate PMI quote, contact your mortgage loan lender.
Can you shop for a cheaper PMI?
As a property buyer, you can only shop around for PMI in the same way you shop around for mortgage lenders. Once you have settled on a lender, you will use whatever PMI provider they choose. The lender may be able to shop around, but you won’t have that decision. Consider this as you’re selecting a mortgage lender and ask specific questions about how they choose a PMI provider.
How is PMI paid?
You may have some options on how you pay your PMI but know you will only make these payments until you reach 20% of the property value in equity.
KEY TAKEAWAY: Equity is the difference between what you owe on your mortgage loan and the value of your home. Principal is the balance of your mortgage loan. As you pay down the principal, you increase your equity.
Ways to pay PMI:
1. Single payment
You can pay PMI “upfront” in one lump sum. This is a good idea if you have the money because your monthly payments will be lower.
2. Monthly payments
This is the most common way to pay for PMI. PMI is paid in monthly payments lumped into your mortgage payments.
3. Lender-paid
This is only an option if you got your mortgage through a lender-paid mortgage insurance program, also known as LPMI.
4. Split payments
Paying a portion of your PMI upfront, and the remainder of your PMI in monthly payments is considered split pay.
Talk with your mortgage lender about what payments options they have available and weigh the options for what is best for your personal situation.
How long do you have to pay PMI?
Your PMI will typically be cancelled automatically by the lender when you’ve paid 22% of your mortgage. When your loan-to-value ratio drops to 78%, the lender recognizes you’re in good standing and PMI is cancelled. According to Bankrate, your PMI will also automatically cancel when you’ve reached the halfway point on your amortization schedule. This is referred to as “final termination” of PMI.
KEY TAKEAWAY: An amortization schedule is the period in which your mortgage is reduced or paid off. For example, if you have a 15-year-loan, the midpoint is 7.5 years, and if you have a 30-year-loan, PMI will stop at 15 years. Of course, you don’t want to be paying for PMI any longer than you must, so if you can cancel it earlier, you’ll want to.
How to stop paying PMI:
1. Pay off your PMI early
If you have extra cash on hand, you may consider paying off your PMI early. But putting that extra cash on your mortgage loan may get you closer to having your PMI cancelled. Do research to see what is financially better in the long run.
2. Request PMI cancellation when mortgage balance reaches 80 percent
Instead of waiting until you reach that 22% of equity, you have the right to request cancellation when you reach 20% paid. To request a PMI cancellation, you should:
- Be up to date on all mortgage payments (it helps if all payments were made on time, too)
- Meet the lender requirements for cancellation (example: no liens, like a second mortgage, on your property)
- Request for PMI cancellation in writing to your lender
You may be required to undergo a home appraisal before your cancellation is approved, because if your home’s value has gone up, you may no longer meet the 20% equity minimum.
3. Refinance your mortgage to get rid of PMI
Talk with your lender about refinancing if industry mortgage rates are lower than your current rate. You could lower your monthly payments and, in the process, gain equity at a quicker rate. But with refinancing comes closing costs, so make sure the savings is worth it in the long run.
4. Reappraise your home to get rid of PMI
If the housing market is up, or you think your home has increased in value, having a new home appraisal may be a good idea. If it appraises at a much higher value than when you purchased it, it may bump you out of the range where PMI is required. Appraisals usually run around $200 to $500 so take this cost into account when deciding if this makes financial sense.
Navigating the private mortgage insurance process can be confusing, but you will deal with many professionals in the home-buying process that are used to answering your PMI questions. They are there to walk you through it all. Alabama Farmers Federation members have access to Farm Bureau Bank, which offers competitive mortgage rates, as one of their member benefits. And our Alfa® agents are ready to get you financial protection for your asset with homeowners insurance. Give your local agent a call for a free home insurance quote!