With mortgage rates at all-time lows, buying a home has never been more attractive. However, many people trying to take advantage of the low mortgage rates struggle to come up with the relatively large down payment required to secure a mortgage. Fortunately for the prospective home buyer, not being able to come up with the down payment will not necessarily result in an automatic loan rejection. Instead, many lenders will allow the prospective home buyer to take out a mortgage with a reduced down payment if they agree to obtain a private mortgage insurance (PMI) policy. But what is private mortgage insurance and how does it help lenders get comfortable with smaller down payments?
What Is Private Mortgage Insurance?
Typically, PMI is required when the prospective home buyer is unable or unwilling to provide a down payment equal to 20 percent of the intended loan. The actual monthly cost of the PMI policy will depend on the size of the down payment, the interest rate and the type of loan. However, a general rule is that a PMI policy will cost somewhere between 0.5 and 1 percent of the total loan. The monthly cost of the mortgage insurance is usually bundled in with the monthly mortgage payment. Note that if you are military veteran, you might qualify for a VA Home Loan which does not require a down payment or PMI.
While PMI allows the prospective home buyer to qualify for a mortgage with a reduced down payment, PMI insurance can be expensive. In fact, a PMI policy can add hundreds or even thousands of dollars onto the homeowner's yearly expenses. For example, according to the PMI calculator offered by GoodMortgage.com, a mortgage loan for $230,000 with an eight percent down payment and a four percent interest rate is subject to a monthly PMI payment of $138 ($1,656 per year) on top of the regular mortgage payment. Over the life of a 30 year mortgage, $138 per month can really add up. The good news is that the cost of the insurance is currently tax deductible.
How To Avoid PMI
The best way to avoid having to purchase a PMI policy is to meet the standard down payment of at least 20 percent of the total loan. However, in the event that you cannot make a down payment of at least 20 percent, there are several strategies which can help you to avoid paying for PMI.
- Lender Paid Mortgage Insurance: With lender paid mortgage insurance, the mortgage lender pays for the PMI policy. However, you should note that a lender will generally raise the interest rate on the mortgage loan in order to cover the cost of the lender paid insurance. Therefore, it is debatable whether or not the homeowner really benefits from lender paid mortgage insurance.
- Piggyback Loans: These loans, known as 80/10/10 loans, break up the total amount borrowed into two different loans in order to make the required 20 percent down payment. In this scenario, the borrower takes out a primary mortgage for 80 percent of the price of the home. The borrower then takes out a second mortgage for 10 percent of the price of the home. The borrower combines the proceeds from the second mortgage loan with money from savings equaling 10 percent of the price of the home. The combination of these funds allows the borrower to make a 20 percent down payment and avoid paying PMI. Those considering this strategy should note that the interest rate on the second mortgage will generally be higher than the interest rate on the first mortgage. However, both types of interest are tax deductible. (For more information on second mortgages, see Helpful Advice On Taking Out A Second Home Loan Mortgage.)
- Single Premium: With a single premium PMI payment, the homebuyer is not technically avoiding PMI. Rather, the homeowner is avoiding making monthly PMI payments by making a one-time insurance payment at the time of the loan closing. This may be a good option if the homeowner is planning to remain in place for at least 5 years with no plans to refinance.
For those who are unable to avoid PMI, it's important to remember that it does not necessarily need to be paid for the duration of the loan. In fact, once you have 20 percent equity in your home, you can usually get rid of the mortgage insurance. There are three ways to reach 20 percent home equity.
- Pay Down The Mortgage: The most common way to eliminate PMI is to pay down the mortgage to less than 80 percent of the home's value. Making your monthly mortgage payments will help reduce the loan-to-value over time. If you can afford it, you might consider making an extra mortgage payment or two in order to reach the 20 percent equity threshold faster.
- Home Value Appreciation: Another way that your loan can get below the 80 percent threshold is through an appreciation in your home value. When the property value of your home increases, the loan-to-value of your mortgage may be reduced to below 80 percent. A reappraisal of the dwelling will be needed to validate the change in value. Once you have built up at least 20 percent home equity, you should request the cancellation of your PMI policy. It's important to note that a lender may decline the request to terminate PMI if there is a second mortgage, the property has declined in value or the loan is not current.
- Refinance: A third way to fall below the 80 percent threshold is to refinance your mortgage loan. If you can refinance your mortgage so that the loan-to-value falls below 80 percent, you should be able to cancel your mortgage insurance. However, there are some risks to refinancing your mortgage. (To learn more, see Reasons Not To Refinance Your Mortgage.)
It is a great time to be in the market for a house. However, if you do not have the funds to make the standard down payment, it's important to be educated on private mortgage insurance. Understanding the intricacies of PMI can save you considerable money in the long-run.