Private mortgage insurance (PMI) is a type of insurance designed to provide extra protection for mortgage lenders in cases where a home loan is considered higher risk. The most common scenario where PMI might be required is when a borrower makes a down payment of less than 20% of a home’s purchase price.
Unlike other kinds of insurance that provide protection for the insured, PMI only benefits the mortgage lender. While it is usually the homeowner that pays for PMI, it is the lender that chooses the insurer and makes arrangements for how you will pay the premium. In the event of a mortgage default, PMI reimburses the lender for a portion of its losses.
Because this insurance protects the lender and not you, you may wonder why you’re required to pay for it. In essence, your mortgage insurance payments compensate the lender for agreeing to take the risk of lending to you even though you’re making a smaller down payment.
Types of private mortgage insurance
Two main categories of PMI are available: borrower-paid mortgage insurance and lender-paid mortgage insurance. Two less common PMI options for which responsibility also falls to the borrower are single-premium mortgage insurance and split-payment mortgage insurance. Let’s explore each of these in more detail.
Borrower-paid mortgage insurance
The most common type of mortgage insurance is borrower-paid PMI. This form of PMI is usually paid on a monthly basis as part of your mortgage payment until you’ve reached a substantial level of equity in your home (about 20%). At that point, you may be able to request that your lender cancel your PMI payments.
Lender-paid mortgage insurance
Lender-paid mortgage insurance differs from borrower-paid mortgage insurance in that it’s technically paid by the lender instead of you. However, you’ll usually pay a higher interest rate in order to compensate the lender for this expense. Even though you won’t see an extra expense added to your mortgage payment, your payment amount will be higher than it would have been without mortgage insurance.
Unlike borrower-paid mortgage insurance, you won’t be able to cancel a lender-paid policy even after your equity has increased. Because the policy’s cost is built into your interest rate, the only way to eliminate its impact is to refinance your mortgage. Even then, unless the current market interest rates are the same as or lower than they were when you initially took on the mortgage, you may not be able to get a better deal.
Single-premium mortgage insurance
Sometimes called “single-payment” mortgage insurance, single-premium mortgage insurance requires only one upfront payment. In most cases, this payment is paid at closing. In some cases, however, it may be combined with the mortgage balance and paid over the life of the loan.
This type of mortgage insurance is advantageous because it can get you a lower monthly payment while still allowing you to qualify for a mortgage without a 20% down payment. In addition, you won't have to worry about canceling your PMI in the future. In a buyer’s market, you may even be able to get the seller to pay this premium for you as part of your offer on a home.
The main drawback to single-payment mortgage insurance is that it’s not refundable. If you sell your home or refinance the mortgage, you won’t be able to get any part of your money back. In addition, if you don’t have the money you need to make the 20% down payment, you may not have enough to pay the upfront insurance premium payment. If the payment is financed into the mortgage, you’ll pay interest on it until the loan is paid off.
Split-premium mortgage insurance
Split-premium mortgage insurance is similar to single-premium mortgage insurance. With this type of PMI, you pay part of your mortgage insurance premium as a lump sum at closing. This upfront premium varies, but it often ranges between 0.50% and 1.25% of the total loan amount. The remaining portion of your mortgage insurance is then paid on a monthly basis.
The nice thing about split-premium mortgage insurance is that it doesn’t require as much money upfront as single-premium mortgage insurance. In addition, it won’t raise your monthly payment as much as traditional buyer-paid mortgage insurance.
Once your loan has reached a certain level of equity, you may be able to ask the lender to cancel the monthly portion of the insurance premiums. However, the upfront premium is nonrefundable.
How private mortgage insurance works
If borrower-paid PMI is required for your home loan, you’ll typically pay a portion of the premium each month as part of your monthly mortgage payment. This premium will be transferred to the mortgage insurance company by the lender to pay for the policy.
Several large PMI companies exist in the U.S., all charging similar amounts for their policies. The exact annual premium required varies but typically ranges from 0.25% to 2% of your loan balance. This amount is divided by 12 and added to your monthly home loan payment. Factors that may impact the amount of your annual mortgage insurance premium include:
Your credit score
The size of your down payment
The type of home loan
The mortgage loan term
In general, the higher your level of risk as a borrower, the larger your PMI premium will be. It’s also important to note that, because PMI is usually calculated as a percentage of your loan balance, your premium will increase as the amount borrowed increases.
What happens if you default on your loan?
No one plans to default on a mortgage. However, if your financial situation changes and you’re unable to make your mortgage payments, your loan will go into default. Eventually, if you’re not able to bring your loan current, your lender will foreclose on the home.
If you default on your loan and the loan is covered by PMI, your lender will be reimbursed for a portion of its loss.
For example, assume you have an outstanding mortgage balance of $100,000 and the mortgage insurance policy covers 25% of your lender’s loss. If you stop making your mortgage payments, the mortgage insurance policy would pay out $25,000 to cover some of your lender’s loss. The policy may also cover 25% of your delinquent interest, as well as 25% of the costs your lender incurs during foreclosure.
FHA mortgage insurance
If you’re applying for a Federal Housing Administration (FHA) loan, you’ll pay an entirely different type of mortgage insurance than the other varieties mentioned above. FHA mortgage insurance is typically referred to as mortgage insurance premium (MIP). This form of insurance is required for every FHA loan and is usually more expensive than the PMI that accompanies some conventional home loans.
If you’re subject to MIP, you’ll essentially face a split-premium situation requiring you to pay both an upfront premium and a monthly premium that will be added to your mortgage payment. The upfront premium required for FHA loans is 1.75% of the loan amount. That means you’ll pay $1,750 upfront for every $100,000 borrowed on the loan.
To reduce your initial expenses, you may be able to roll this upfront premium into the loan and pay for it over the term of the loan. However, if you decide to go with this option, you’ll pay interest on it as well. The monthly MIP you’re required to pay will depend on your down payment as well as the length of the loan term. Monthly MIP ranges from 0.45% to 1.05% of the loan amount, divided by 12.
If your down payment is more than 10% of the original loan amount, you can cancel your monthly MIP after you’ve made your payments for 11 years. If your down payment is not more than 10% of the original loan amount, you won’t ever be able to cancel these monthly premiums.
Benefits of private mortgage insurance for borrowers
Although PMI increases the overall cost of your mortgage and is primarily focused on protecting the lender, it can have advantages for buyers. For one thing, PMI can allow you to buy a home right away, even if you’re unable to make a 20% down payment. In addition, if you’re currently spending money on rent, you may find the added expense of mortgage insurance is more lucrative in the long run since it enables you to become a homeowner and begin building equity.
That said, there’s no guarantee that buying a home now will be more beneficial than waiting until you have enough money saved to make a 20% down payment. For this reason, it’s important to do plenty of research and consider your options carefully before you take on a loan that includes PMI.
Getting rid of private mortgage insurance
With both buyer-paid and split-premium mortgage insurance, you’ll eventually have the opportunity to cancel your policy and save money on your monthly payments. Once your loan’s balance reaches 80% of the original purchase price, you can typically ask your lender to terminate your PMI policy.
If you don’t request to have the policy canceled, the lender must automatically cancel the policy for you once your loan’s balance reaches 78% of the original purchase price. This requirement was established by the Homeowners Protection Act of 1998.
Is it possible to avoid private mortgage insurance?
PMI can help you buy a home when you aren’t able to afford a 20% down payment. In addition, if you have a low credit score or other factors that make it difficult for you to qualify for a conventional loan, paying FHA mortgage insurance or PMI may be the only way to get a loan. However, there are three ways to avoid paying PMI altogether:
1. Look for a loan that doesn’t require PMI.
Some loan programs may not require PMI even when you’re unable to make a 20% down payment. For example, loans backed by Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA) don’t have a mortgage insurance requirement.
Some lenders may also offer specialty loan programs that don’t force you to pay PMI, especially if you have other compensating factors to make up for your smaller down payment.
2. Save up for a 20% for a down payment.
Perhaps the easiest way to avoid paying PMI is to keep saving money until you have enough to make a 20% down payment on the house you want. Although saving money can be a challenge, it may make your life easier in the long run if you’re able to avoid this added monthly expense.
You can save money by looking for ways to trim your current budget, getting a side job or selling things you don’t need. You can put even more money away by skipping some unnecessary expenses, such as vacations or gifts.
3. Cancel PMI as soon as possible.
If you can't avoid paying PMI altogether, you can reduce its impact on your finances by canceling it as soon as possible. Keep careful track of your loan balance and request a cancellation of your PMI immediately after your mortgage has reached 80% of the original value of your home.
If you’re able, consider making extra payments toward your mortgage principal so you can cancel PMI even sooner. Be sure to make all of your mortgage payments on time, as your lender is unlikely to cancel your mortgage insurance unless your loan is current.
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