Private mortgage insurance (PMI) is a specific type of insurance for mortgage holders. Its purpose is protecting lenders should a borrower fail to make payments on the loan. Not to be confused with homeowner’s insurance that covers property damage and theft, private mortgage insurance gives lenders a route for compensation if borrowers bailout. Let’s explore more about PMI and discuss when it’s needed and when it’s not.
How Does PMI Work?
Lending underwriters consider a loan-to-value (LTV) ratio as a measure of a borrower’s purported loan risk. The underwriter takes the amount of the loan and divides this figure by the home’s estimated value. If the resulting calculation is greater than 80%, lenders will request a 20% down payment to make up that difference or require the buyer to carry private mortgage insurance.
This coverage is usually mandatory up until the equity through payments reaches 22.2% after which the insurance can be cancelled. Like property taxes, PMI is typically factored into the estimated monthly payments, but it can also be paid up front as a premium when closing. However, this might not be financially savvy if the home isn’t valued at $125,000 or more, as the insurance premium may be more than the 20% down payment in the long run.
Types of Loans That May Require Private Mortgage Insurance
In general, PMI is only applicable within the scope of what are known as conventional fixed-rate, adjustable rate and jumbo loans where a banking institution puts up the financing for a mortgage. Individuals that don’t have a 20% down payment or enough up front to put down to balance out the loan-to-value ratio will need private mortgage insurance.
That being said, there are a few programs that offer PMI-free home loans. While these options are scarce, certain lenders will waive PMI mandates for those who don’t have 20% up front, but these come at a higher interest rate and should be carefully thought out prior to signing up for such a program. However, mortgages from the Federal Housing Administration (FHA) and other government backed loans may have their own specific PMI requirements.
PMI and Non-Conventional Loans
If you are a veteran using a VA loan, you won’t be required to carry private mortgage insurance whatsoever. Those using a US Department of Agriculture program will also not be required to have mortgage insurance.
However, some loans such as FHA mortgages do have their own form of insurance. For example the FHA requires and up-front mortgage insurance premium that is to be paid via additional financing for the loan or in cash at the time of closing.
The rates for mortgage insurance through FHA loans are typically lower than traditional PMI’s, and there may be options to pay annually for qualified borrowers. The catch here is that there is no cancellation of coverage once the equity threshold has been achieved, making it a potentially more expensive loan option in the long haul.
Private mortgage insurance can run anywhere between .5 and 1% of the total loan amount, so if you can put 20% down to avoid it, do so. If not, consider taking out a small loan to cover the costs of PMI, an act known as ‘piggybacking.’ Otherwise, look into government-backed loans from the VA, USDA, and the FHA for alternatives.
Is Private Mortgage Insurance a Good Thing?
PMI can be beneficial to first-time buyers in particular, as they are a greater risk of defaulting and can benefit during the tax season by getting a deduction for not only their mortgage but for the insurance premiums. While it may add to monthly loan costs, it can be a great way to get one foot inside the homeownership bubble.