Despite what you’ve been told, or what you currently think about private mortgage insurance (PMI), it’s actually a tool that helps many buyers obtain their dream of homeownership.
PMI is the reason all buyers aren’t required to put down a 20% deposit on a home. It’s also a way for many buyers to have low, or even no, down payment options available to them.
What exactly is PMI and how does it work? This article answers those questions and more!
What is Private Mortgage Insurance (PMI)?
Private mortgage insurance (PMI) is required when you take out a mortgage with less than 20% down. Mortgage insurance covers the lender if you (the borrower) fail to make your mortgage payments.
It is arranged by a lender and provided by private insurance companies. The reason that it is required with less than 20% down is because of the risk the lender is taking on. If you are financially responsible to pay a 20% down payment, you are more likely to be able to pay off the loan entirely.
That’s why you have to pay PMI until 20% principal is paid off of your mortgage loan. Once you have proven to the lender you are capable of consistently making payments, they will see you are financially responsible and less of a risk.
To find out if you can afford a 20% down payment, use our mortgage calculator.
How Does PMI Work?
If your PMI policy pays out, the lender receives the money – not the borrower. In most cases, private mortgage insurance is non-negotiable. Meaning no matter how much you shop around and compare rates, if you don’t put 20% down it’s required.
PMI works like this, when you apply for a mortgage, you will be told by the lender if you must take out private mortgage insurance. Homebuyers who get conventional loans or put less than 20% down on a home are required to pay PMI.
If you do have to pay PMI, your lender will tell you how much the premium will cost, and this amount will be part of your monthly mortgage payment. PMI costs range from 0.25% to 2% of your loan balance per year, depending on the size of the mortgage and down payment, the loan term, and credit score of the borrower.
The Purpose of Private Mortgage Insurance
Once you are pre-approved and committed to taking out a mortgage you must pay back the amount you owe, plus interest. Research shows that homebuyers who have less than 20% of the home’s price value as a down payment are more likely to default on their mortgage.
If a homeowner defaults on their loan, the lender must go through a costly foreclosure process. Additionally, if the loan defaults in the early stages of the mortgage, the amount that the lender gets for the home once it sells may not amount to the outstanding loan.
Since this scenario happens all too often, the government supports private mortgage insurance to help lenders recoup their costs.
Without PMI, lenders would require a 20% down payment from all borrowers before offering a mortgage.
Different Types of PMI
There are 4 main types of mortgage insurance you can purchase – these do not include the insurance offered by government-backed loans such as FHA. The type of PMI you choose determines the length of time that you’ll make a higher monthly mortgage payment.
Borrower-Paid Mortgage Insurance
This is the most common type of PMI because there are no upfront costs and no waiting period to cancel when it’s time. This insurance is tied directly into your monthly mortgage payments and can be canceled when your loan drops to 78% of your home’s value.
If you’re unsure of how long you’ll keep your mortgage, this is the insurance you should look into.
Single-Premium Mortgage Insurance
If you want to eliminate the monthly PMI payment, this type of insurance allows you to pay the PMI upfront in one large sum. It’s a non-refundable transaction with a lot of risks associated.
Lender-Paid Mortgage Insurance
In exchange for the lender paying your mortgage insurance for you, your mortgage rate is increased. This type of insurance cannot be canceled because it’s built into the interest rate. Borrowers who plan to keep their mortgage for 5 to 10 years often use this insurance policy.
Split-Premium Mortgage Insurance
Homeowners also have the option to pay a portion of their PMI in a lump sum at closing and the remaining amount in monthly payments.
Each mortgage insurance type comes with its own advantages and risks that fit various situations. Choosing the right one can put you in an ideal home buying position.
When Can You Drop Private Mortgage Insurance?
If you choose a PMI type like borrower-paid mortgage insurance, then you can cancel your PMI once the mortgage’s LTV ratio falls to 78%. Your lender should do this automatically as long as your current on your mortgage payments.
However, there are other ways you can remove your PMI before reaching this point. First you must meet certain criteria:
- Send your lender a request in writing for early removal of PMI.
- Have at least 2 years of good payment history.
- Provide proof of the home’s current value.
- Ensure there are no loans against the property.
If you meet these criteria, work on paying down your mortgage or consider refinancing your home.
To find out more about private mortgage insurance and how you can avoid paying it, speak with an experienced loan officer.