What is private mortgage insurance?
Like other types of mortgage insurance, private mortgage insurance (PMI) protects the lender in the event the borrower stops making payments on the loan. The lender obtains PMI from a private insurance provider. When required, PMI becomes part of a borrower’s monthly mortgage payment, along with principal, interest, homeowners insurance and property taxes. PMI is for the benefit of the lender, not the borrower, so you should cancel it as soon as it is legally possible.
Types of mortgage insurance
One way of classifying home loans is by how they are financed. Private lenders, such as banks and credit unions, provide traditional mortgage loans. Federally approved private lenders also may offer government loans such as FHA and VA loans. Lenders may require PMI for private loans, depending on the borrower’s risk profile. Federally financed loans require an insurance payment called a Mortgage Insurance Premium (MIP) that is administered and managed by their respective programs. The rules for MIP are different from those for PMI.
Requirements
Private lenders typically require you to carry PMI on your mortgage unless you make a minimum down payment as required by the lender, typically at least 20% of the house’s appraised value. You can stop paying PMI when your equity reaches the lender’s minimum requirement. Government loans normally require mortgage insurance for the life of the loan, regardless of the amount of equity you have in your home.
Payments
The cost of PMI is based on the perceived risk that you pose to the lender, which generally means that a higher down payment and better credit score will reduce your PMI payment. Typically, PMI costs $30-$70 per month for every $100K you borrow. For example, if you borrow $300K, you can expect your PMI payment to be around $150 per month.
The procedure for paying your PMI premium depends on your particular mortgage. Most lenders simply add it to your regular monthly payment, although some may require you to make a separate payment directly to the insurer. Some lenders offer a type of PMI insurance that allows the borrower to pay off PMI in a lump sum upfront, eliminating monthly payments.
Benefits
The primary benefit of PMI is to minimize the risk to lenders in providing a loan to borrowers who can’t make a large down payment. These borrowers lack the equity that normally would be used to help pay the mortgage balance in the event the home goes into foreclosure. With PMI, the insurance carrier pays the balance on the loan should this occur.
PMI doesn’t protect a borrower who falls behind on mortgage payments, but it does provide tax advantages. All types of mortgage insurance in the U.S. became tax-deductible in 2007, which reduces the overall cost of PMI for homeowners. In some cases, this law means that it now costs less for a borrower to simply get PMI than to take out an additional loan to make the 20% down payment that will avoid it.
The tax law now allows homeowners with an annual income of no more than $109,000 to claim an itemized deduction for PMI payments. PMI policies issued before 2007 aren’t eligible for deduction.
Avoiding PMI
The simplest way to avoid paying mortgage insurance is to put 20% or more down on your home. This option applies only to conventional loans, since government loans always require mortgage insurance.
Another option is to take out a second loan known as a “piggyback” loan, which covers the additional amount you need for the 20% down payment. The disadvantage of this approach is that a piggyback loan usually has a higher interest rate than the primary mortgage loan, although the interest is typically tax-deductible. Before selecting this option, you will need to consider whether you can afford to make payments on the two loans. Your financial planner or tax adviser can provide more specific information to help you make a decision that is right for you.
Some lenders offer mortgage products specifically designed to reduce PMI requirements. For example, Bank of America launched a product called Affordable Loan Solution in 2016 through a partnership with Freddie Mac and Self-Help Ventures Fund. This loan allows home buyers of low to moderate income to waive PMI with a 3% down payment. The Affordable Loan Solution conforms to Fannie Mae and Freddie Mac requirements for federally financed loans.
Other lenders offer non-conforming loans with down payments of 10-15% that don’t require PMI. Some credit unions will waive the PMI requirement for customers who can’t make a 20% down payment, provided their credit profile is strong enough.
Veterans who qualify for a VA loan may be able to obtain a no-down-payment mortgage with no mortgage insurance requirement. A VA loan may require an upfront funding fee, but some veterans are exempt from the fee.
Canceling PMI
You can cancel PMI once your equity reaches a minimum percentage of the house’s original appraised value as specified by your lender, usually 20%. It’s important to take this step as soon as you qualify, because cancellation of PMI can significantly reduce your monthly payments. Unless you notify them, lenders often won’t cancel PMI automatically as soon as your equity makes PMI unnecessary. Instead, they will wait until your equity reaches a value slightly above the minimum, often 22%.
Summary
PMI provides private lenders with a safety net in case the borrower is unable to make mortgage payments. Lenders generally require PMI for homebuyers with small down payments, although some options for reducing the down payment needed to waive PMI are available. Tax implications are another factor to consider when evaluating the total cost of PMI. In general, borrowers will want to cancel PMI as soon as they can.
