Private Mortgage Insurance(PMI)
What is a PMI?
Private Mortgage Insurance (PMI) is insurance that protects your lender against non-payment should you default on your loan. It is an extra insurance that lenders require from most homebuyers who can’t afford to put down 20% of home value as down payment. PMI should not be confused with homeowner insurance because the only purpose of this insurance is to protect your lender and not you but you as a homebuyer will be paying the premium for this coverage. PMI is often required by lenders due to the higher level of default risk that's associated with low down payment loans. PMI allows people to purchase home without having to come up with 20% of the price up front. Most new home buyers put down as little as 0–5 percent down payment and they will have to wait years before they could save enough to put down 20% down payment on a house so loans with PMI offer an opportunity to reduce that wait and purchase their dream homes sooner.
Benefits of PMI
PMI plays an important role in the mortgage industry as well as in real estate market. Even though PMI is primarily used to protect a lender, it enables borrowers with less cash to have greater access to homeownership. If you’re willing to pay PMI, it is possible to buy a home with as little as a 3 percent to 5 percent down payment. This means that you can buy a home sooner without waiting years to accumulate a large down payment. Here is an example to understand it better. Let’s say you have $10,000 saved toward your home purchase. Now if you’re looking to buy a home with 20% down payment, most you can afford is a $50,000 home. As you can see, it is almost impossible to find a decent home anywhere around the country for $50,000. However, if you’re willing to pay PMI, and putting down 5% towards your down payment, you can buy a $200,000 home with your $10,000 initial investment. Now it is possible that a homebuyer with $10,000 may not be able to afford a $200,000 home? It is definitely possible that this home buyer may not be able to make monthly payments on a $200,000 but PMI has expanded the price affordability from $50,000 to $200,000 and thus making it more likely that buyers will be able to find something in their price range.
This is the value of private mortgage insurance -- it is the main reason why so many young families today can afford homeownership despite earning and saving relatively less than their parents. Also, PMI is one of the main reasons for the growth in real estate market. PMI has made it possible for families to buy a home for as little as 5% down payment, and in turn generating more buyers in the market. Unfortunately, some people continue to confuse private mortgage insurance with mortgage life insurance. Private mortgage insurance puts people in homes; mortgage life insurance pays all or a portion of your mortgage in the event of your death.
Cost of PMI?
The average costs of mortgage insurance premiums vary, but typically they fall between one-half and one percent of the loan amount, depending on the size of the down payment and the loan. For example, on a $300,000 loan with a $20,000 down payment, you might expect to pay somewhere around $230 a month, or about $2,760 a yea in PMI, in addition to your mortgage payment. One of the most important things to remember is that unlike your mortgage interest, these premiums are not tax deductible. Also, PMI does not vary from one home owner to another based on their credit history or income. PMI is based on the size of the mortgage and amount of money put down as down payment. So whether your credit score is 850 or 500, you’ll pay same PMI as long as mortgage loan amounts and down payments are identical. When considering the cost of PMI, you should also consider the duration of loan. If you’re applying for a 30 or 40- year fixed mortgage, it will take you lot longer to pay down 20% of home value as compared to a mortgage loan that is 15-year fixed. Also, if you have other types of mortgage loans such as “interest only”, you will pay PMI as long as you have the loan since you’re not paying any principal amount and in effect will never build any home equity in the home except due to price appreciation. |
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Most people don't understand the true cost of PMI as it is included in their monthly payment and they don't have to write a separate check for it. However, as you can see from the following table, PMI could cause a substantial burden on homeowners. Data in this table is based on a $200,000 home with 6.5% interest and 30 year term.
| Down Payment Percentage |
5% |
10% |
15% |
20% |
| Down Payment(Home Equity) |
$10,000 |
$20,000 |
$30,000 |
$40,000 |
| Monthly House Payment(P+I) |
$1,200 |
$1,137 |
$1074 |
$1011 |
| Monthly PMI Premium |
$124 |
$78 |
$45 |
$0 |
PMI, Home Owner Insurance, Mortgage Protection Insurance
As you can tell by now, Private mortgage insurance is there to protect your lender in case you default on your payment. PMI does not protect you as a homeowner. Mortgage protection insurance is an insurance that is designed to make payment on your mortgage loan in the event of your death. Homeowner insurance is another product designed to protect your home in case of natural disaster or fire. Home owner insurance policy also includes your other properties such as furniture and home items in addition to home itself. Most lenders require that you purchase a homeowner insurance policy before you can complete the home purchasing. It is also important to understand that while homeowner policy will protect against natural disaster, it usually excludes flood damages and you’ll have to purchase additional coverage for flood insurance. Flood insurance premium will vary based on the size and location of your home.
Canceling or Terminating PMI
PMI is not tax deductible like interest on your mortgage loan so it makes sense to get rid of it as soon as you can. Ideal solution would be to purchase a home with 20% down payment but most people find that difficult. However, there are options even if you don’t have 20% down payment to get rid of PMI. Here are a few ways to eliminate mortgage insurance altogether:
When buying a new home: - Mortgage industry has come up with alternative option of piggyback mortgage loans that allows home owners to avoid paying PMI. Piggyback loan is usually a “80/20 loan” that allow you to avoid private mortgage insurance. In fact, a “80/20 loan ” can be used to avoid any “out of pocket” down payment with the added benefit of a tax deduction. You apply for a first mortgage(usually 80% of the home value) and then piggyback a second mortgage onto your first mortgage. This is a good option but it has a downside of having a substantially higher interest rate on the second mortgage. Your saving may end up negligible with a “80/20 loan”. However, this option is useful if you choose to go with a “80/10/10 loan” with last 10% going towards the down payment. This option can save you some money in taxes as interest on second mortgage is also tax deductible.
If you already live in your home: If you’re an existing homeowner, there are certain steps you can take to eliminate PMI.
Appraisal – If you live on one of the fastest growing real estate market, changes are that your home value has risen substantially in recent year. This allows you to get a second appraisal done and may get you to that magic 80% loan-to-value ratio that is required by most lenders. For example, if you bought a $100,000 loan with no down payment and have paid 5,000 in last 5 years, you still owe $95,000 in loan. Now if your home has appreciated by 20% in last 5 years, your home is now worth $120,000.
Your new loan-to-value ratio would be $95,000/$120,000 = 79.16% which is clearly less than 80% as required by most lenders. So by getting a appraisal done, you can eliminate the PMI. You would, of course, have to present your lender with a valid home appraisal before final termination. The costs associated with getting an appraisal may or may not be worthwhile, depending on your unique mortgage situation.
Remodel
It's the same principal as above. By making home improvements, you're increasing the market value of your house, getting you that much closer to the all-important 80 percent "LTV" level.
Pay down your mortgage
Paying down your mortgage may also be a viable option. Making even small additional payments each month can make a big difference over time. Once you get that loan-to-value-ratio below 80 percent, you'll no longer be required to make PMI payments.
Automatic termination
Thanks to The Homeowner's Protection Act (HPA) of 1998, you have the right to request private mortgage insurance cancellation when you reach a 20 percent equity in your mortgage. What's more, lenders are required to automatically cancel PMI coverage when a 78 percent loan to value is reached. Some exceptions to these provisions, such as liens on property or not keeping up with payments, may require further PMI coverage.
Without a doubt, private mortgage insurance has proven invaluable for families trying to attain the American dream of homeownership. It affords these individuals an opportunity that isn't always easily achieved in this otherwise inflated real estate market. Paying more or longer than needed isn't prudent, however, and it's highly recommended that all steps are taken to avoid unnecessary payment. Knowing when to cancel can save you thousands, so make sure to utilize all the resources available to you and cancel when you reach the proper equity level, otherwise, it's just money down the drain.
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