Purchasing a home is one of the most significant decisions you will make in your life.
As a homeowner, you have a lot to consider, and it can be quite overwhelming figuring out how to finance everything.
You need to think about how much money you can afford for your down payment, what kind of loan you are going to get, and whether or not you are going to have private mortgage insurance (PMI).
What Is PMI?
Private mortgage insurance, or PMI, is a type of coverage that helps protect lenders from losses if the borrower defaults on their loan.
This can be beneficial for both borrowers and lenders, as it allows borrowers to secure financing for their home without having to make a sizeable down payment, and lenders are protected if the borrower is unable to make their payments on the loan.
PMI is required on most types of mortgage loans, including conventional home loans. Borrowers are typically required to pay PMI premiums in monthly installments along with their mortgage payments.
The amount of the PMI premium can vary depending on the type of loan, the size of the down payment, and the borrower’s credit score, which will be discussed in further detail below.
How Does PMI Work?
The lender will purchase insurance from a private insurer to cover a portion of their potential loss if the borrower defaults on the loan.
The amount of loss is calculated based on what’s known as the loan-to-value ratio (LTV), which is determined by dividing the total amount owed on your mortgage by the value of your home.
The higher your LTV ratio is, the greater the risk to the lender. As such, loans with high LTV ratios will typically require PMI, while those with lower ratios may not.
While PMI may seem like an extra expense that you’d rather avoid, it can help borrowers secure the financing they need to buy a home without having to make a large down payment, which can be difficult for many people, especially first-time homebuyers.
Types of PMI
There are four types of private mortgage insurance policies: borrower-paid, lender-paid, single premium, and split premium.
Borrower-Paid PMI – The most common type of PMI is borrower-paid. As the name suggests, the borrower pays a monthly premium to the lender, which is then added to the mortgage payment. This is typically the least expensive type of PMI. With this type of policy, the borrower can request that the PMI be removed once they’ve reached a certain level of equity in the home.
You may hear this referred to as “cancellable” or “automatic” PMI because it will cancel itself after the borrower has built up enough equity. The downside to this type of policy is that it can be expensive for your monthly budget, especially if you have a smaller or less expensive home loan. But, the good thing is that you don’t have to pay the PMI all at once, and again you can cancel it when you reach the equity levels.
Single-Premium PMI – This type of policy is, as the name suggests, only required to be paid once. It can also be called “lump-sum” or “non-cancellable” private mortgage insurance.
With this form of PMI, you are required to pay a large premium right up front rather than paying monthly premiums. This means you will have a more expensive initial payment, but it can also be well worth it as you are done for the life of your loan.
Because this policy is non-cancellable, which means you cannot cancel it even if you reach the required equity levels, it is typically only used when the borrower has a very small down payment.
This policy may be a good option for you if you don’t want the hassle of having to pay monthly premiums or if you want to save on interest over the life of your loan.
Split-Premium PMI – Split-Premium PMI is a hybrid of the two previous types of PMI in that it requires both an upfront payment as well as monthly premiums.
With this type of policy, you pay a lower premium at closing and then continue to pay monthly premiums. The advantage of this type of policy is that it offers the borrower some initial savings while still protecting monthly payments.
This policy is well-suited for borrowers who have a larger down payment but would still like to save some money upfront.
Lender-Paid PMI – The fourth and final type of PMI is lender-paid. As the name suggests, with this type of policy, the lender pays the monthly premium to the insurer on behalf of the borrower.
Great as it may sound, keep in mind that you will be paying for this one way or another.
If a lender isn’t charging you a higher interest rate to pay for the PMI, then they are most likely making up for it with fees and other costs that may make your loan more expensive than it needs to be.
This is typically only an option for borrowers who have a lot of equity in their homes, so it is not often the best choice for most people.
However, if you are looking to be “free and clear” of PMI as soon as possible or do not have many other options, then this may be something worth looking into.
How Much Is Private Mortgage Insurance?
Private mortgage insurance costs will vary depending on some factors, such as:
- The type of PMI policy you have
- The size of your down payment
- The loan amount
- The length of your loan term
- Your credit score
Typically, PMI will cost around 0.5% – 1% of the outstanding loan balance per year. You can expect to pay less for borrower-paid policies and more for single and split-premium policies since you are paying a large amount upfront or making monthly payments.
Let’s put this into perspective with an example. Say you have a $450,000 loan with a down payment of $45,000 and PMI that costs 0.5% per year. If you keep the loan for 30 years at 4.5%, your monthly PMI payments would be $169 and your total PMI payments would be $12,396.
Of course, this is just an estimate and it can vary greatly depending on many factors.
Always be sure to speak with your lender or loan officer about how much PMI will cost for your specific situation so that you know what to expect when applying for a home loan.
It’s better to be prepared and have a clear understanding of all the costs associated with homeownership so that there are no surprises down the road.
How Is Private Mortgage Insurance Calculated?
To calculate the cost of PMI, ask your lender or loan officer to run a quote for your specific situation.
Since many factors go into the calculation, it is important to have a personalized assessment done so you get an accurate estimate of what PMI will cost. You can also use the steps below to get a rough idea of how PMI is calculated.
Step 1: Identify the Property Value
The first step in calculating the cost of PMI is determining your property value. This is based on an appraisal done by a professional appraiser, which ensures that you are paying for protection that is commensurate with the home’s actual market value.
Step 2: Check the Loan Amount
Next, you will need to determine your loan amount. This is usually the purchase price of the home minus your down payment.
Step 3: Calculate the Loan-to-Value Ratio
The next step is to calculate your loan-to-value ratio or LTV for short. This will tell you how much of a mortgage you will need to take out in relation to the value of your property. Check the formula below to calculate your LTV.
LTV ratio = MA / APV
MA – Mortgage Amount
APV – Appraised Property Value
Step 4: Estimate the Annual PMI Premium
You can ask your lender or loan officer for an estimate of the annual PMI premium, or look it up yourself using a PMI online calculator.
The premium is a percentage of the loan amount, and the rate will vary depending on the size of your down payment, your credit score, and other factors.
Private Mortgage Insurance Refinance
Refinancing PMI is the process of removing PMI from your home loan by taking out a new loan to pay off the current one.
This option can be useful if you want to switch to a different type of mortgage that does not require PMI or simply want to save money on monthly payments.
But, there are things that you should keep in mind when considering a refinance to remove PMI.
For one, getting a new mortgage will likely result in higher interest rates, which means that you will pay more over the life of your loan. But, depending on your situation and goals, this may be worth it to eliminate PMI payments.
Another factor to consider is how long you have left on your current loan term.
In most cases, you will not have enough equity to refinance if you have less than five years remaining. Additionally, there may be limits on the size of your new mortgage, depending on where you live or your credit score.
FAQs
Are private mortgage insurance premiums tax-deductible?
Yes, private mortgage insurance premiums are tax-deductible for homeowners that itemize their deductions on their federal tax forms.
How to avoid private mortgage insurance?
To avoid private mortgage insurance, you can:
- Put 20% down.
- Get a piggyback loan.
- Make extra payments on your mortgage.
- Refinance once you have 20% equity.
How much does private mortgage insurance cost?
PMI premiums vary, depending on the size of the down payment and the loan, from around 0.5% to about 1% of the original loan amount per year.
Who benefits from private mortgage insurance? / Who does private mortgage insurance protect?
Private mortgage insurance is designed to protect lenders against losses that may occur if a borrower defaults on their mortgage loan.
It provides financial security for the lender, helping them to recoup some of the costs of foreclosure and loss of property value.
When does private mortgage insurance stop?
Private mortgage insurance typically stops automatically once the loan balance falls below a certain level (often 80% of the original value of the home), or when you reach the end of your loan term.
Can I get a refund on my PMI?
It is possible to get a refund of your PMI premium, but it is not guaranteed. If you have paid off a significant portion of your loan, or if your home’s value has increased, you may be eligible for a refund. You will need to contact your lender to see if you qualify.
Conclusion
Private mortgage insurance is a type of insurance that provides coverage to lenders if a borrower defaults on their mortgage payments and is unable to repay the loan balance.
Private mortgage insurance is typically required for borrowers who have less than 20% equity in their homes or when taking out a high-ratio mortgage.
The need for private mortgage insurance can be avoided by saving up enough money for a down payment or by choosing an alternative to a high-ratio mortgage.
Private mortgage insurance is a necessary financial safeguard for lenders that allows them to feel more secure about providing mortgages to borrowers with lower down payments.
Because these borrowers are seen as being at higher risk of defaulting on their loans, lenders must take additional steps to protect themselves if this does happen.
Private mortgage insurance gives lenders this peace of mind, and in turn, allows more borrowers to qualify for a home loan.
While private mortgage insurance is not required for all borrowers, it is something that should be considered if you are looking to purchase a home with less than 20% down.
By understanding how private mortgage insurance works and how it can benefit you, you can make the best decision for your financial situation and your future homeownership goals.
Sources:
https://www.investopedia.com/mortgage/insurance/#toc-cost-of-private-mortgage-insurance-pmi
https://www.consumerfinance.gov/ask-cfpb/what-is-private-mortgage-insurance-en-122/