You’ve searched and finally found a home to buy. But now, your lender throws you a curveball and requires that you pay for Private Mortgage Insurance (PMI). So, what is PMI exactly?
Private mortgage insurance (PMI) protects the lender financially if you stop making payments and default on your home loan. The insurance may be purchased by your mortgage lender at closing, with the costs passed on to you as part of your monthly mortgage payment..
While it’s intended to protect the lender, PMI premiums do offer some benefits to you as a borrower. There are also ways you can minimize the amount of PMI you need, avoid paying PMI altogether , or get rid of PMI after you’ve purchased your home. Let’s dig in.
Why you need to pay for PMI
Lenders typically require PMI for conventional loan borrowers who make a down payment that’s less than 20% of the home’s purchase price. So, let’s say you buy a home for $250,000. A down payment of less than $50,000 means you’ll probably need to pay PMI.
Why do lenders require PMI in this scenario? Because they view borrowers with less than 20% equity in their home as a greater risk than those with 20% or more. They want some form of insurance for borrowers who may stop making payments. Basically, PMI protects the lender in the event that you default on your loan.
How do you pay PMI
Your mortgage lender will let you know if you’re required to pay for PMI. They’ll also handle the legwork of arranging a policy with an insurance provider of their choice. Once the PMI cost is known (more about this below), the lender will add the payment amount directly to your mortgage. You’ll then pay the PMI premium as part of your monthly mortgage payment.
The lender may give you an option to pay the PMI premium in full, as part of your closing costs. While this adds significantly to the upfront cost of buying a home, it usually results in a lower overall PMI premium.
Yet another option is known as lender-paid PMI (LPMI). With this, the lender will pay the PMI premium but charges you a higher interest rate for the loan.
The costs of PMI
As with almost any type of insurance product, the cost of PMI varies between insurance providers and shifts over time based on market forces. The cost also depends on two key factors directly related to you as a borrower.
- Your loan-to-value (LTV) ratio. This is a way of expressing your equity in your home. If you make a 10% down payment, your LTV ratio is 90%. If you make a 3.5% down payment, your LTV ratio is 96.5%. Generally, a higher LTV ratio (a lower down payment) will drive your PMI costs higher.
- Your credit score. Paying bills on time and having other responsible credit habits should lead to a higher credit score. It should also lead insurers to consider you a lower risk to default on your mortgage, which in turn will help lower your PMI costs.
According to Experian, PMI generally costs around 0.2% to 2% of the loan amount per year. Again, these costs will vary based on the factors described above.
Here’s a quick example: You buy a $250,000 home with a $25,000 down payment (10%). The initial loan amount is thus $225,000. Based on your LTV ratio, credit score, and other factors unique to a borrower, let’s say the PMI premium is 1% of the loan amount. So, your annual PMI cost is $225,000 x .01 = $2,250. This is split equally among your 12 monthly mortgage payments, so you pay $187.50 per month for PMI in addition to the principal and interest payments.
To conduct your own calculations, check out our mortgage payment calculator which lets you include the cost of PMI into your monthly payment estimates.
How to avoid paying for PMI
For a conventional loan, the surest way to avoid paying for PMI is to make a down payment of at least 20%. This results in an LTV ratio of 80%, which doesn’t require PMI.
You might also consider getting a piggyback loan. This is a home equity loan or home equity line of credit that lets you borrow additional money to put towards your down payment. However, these loans usually come with higher interest rates. Make sure that paying back the piggyback loan doesn’t cost you more in the long run than paying for PMI.
If you simply can’t afford 20% and a piggyback loan isn’t a sensible option, be aware that you can stop paying for PMI once your loan-to-value (LTV) ratio hits a certain threshold. Over time, as you pay down the principal on your mortgage and grow your equity in your home, your LTV ratio will eventually drop to 80%. You can then contact your lender and request to have PMI removed. By law, the lender is required to remove PMI automatically when your LTV ratio is 78%.
Bear in mind that your loan-to-value ratio will also be affected by any increase in home value based on the housing market (values have increased significantly across the country since 2021) or any home improvements you make. If you believe your home’s value has increased to the point where your LTV ratio has dropped below 80%, contact your lender to find out what’s required to get rid of PMI. They’ll likely need you to have a property appraisal and be current on your monthly mortgage payments.
PMI and government-backed mortgage programs
Government-backed loans may be another option to help you avoid PMI. These loans have their own forms of lender insurance but with lower thresholds for the borrower’s down payment.
For instance, Federal Housing Administration (FHA) loans require what’s known as mortgage insurance premium (MIP) for down payments lower than 10%. Veterans Administration (VA) home loans include a funding fee, paid for by the borrower, instead of PMI. And United States Department of Agriculture (USDA) home loans require the borrower to pay modest annual fees to insure the loan.
Is PMI good or bad?
For a long time, a 20% down payment was a requirement for most mortgages. From the lender’s perspective, that 20% equity was protection if the borrower defaulted. Borrowers with minimal savings had to find other ways to get money for the down payment or simply wait to buy a home.
All this changed in the 1970s when the PMI industry was born. Now, with that protection being provided to the lender by a third-party insurer, many people who cannot afford a significant down payment can still buy a home.
Additional questions about PMI
Is PMI tax deductible?
According to the Internal Revenue Service, PMI is tax deductible for the tax year 2021. However, as the rules surrounding this deduction have changed frequently in recent years, it’s a good idea to consult with a tax preparer.
Is PMI the same as homeowners insurance?
PMI is not homeowners insurance. PMI, as stated above, protects the mortgage lender in case you default on your loan. Homeowners insurance protects you if your home is damaged or destroyed by fire, storms, theft, or other catastrophes. You need to shop for and buy a homeowners insurance policy when you buy a home.
Borrower vs. lender-paid mortgage insurance: which is better?
With lender-paid PMI (LPMI), the lender pays the premium but charges you a higher mortgage interest rate. Deciding whether borrower-paid or lender-paid PMI is better means doing a little math to determine which will cost you more over time. Your lender should be able to help you decide which is better for you.
The bottom line? While the added expense may be a tough pill to swallow, PMI is a bridge to homeownership for many Americans. With a little knowledge, you can avoid PMI or minimize its impact on your finances.