Private Mortgage Insurance (PMI) is one of the many kinds of home insurance policies out there. It is provided by private insurance companies to safeguard lenders against a loss they may sustain in case a borrower defaults. A majority of lenders need PMI in cases where a homebuyer makes a down payment, which is less than twenty percent of the purchase value or price of the home, or in technical terms when the loan to value (LTV) ratio of the mortgage is greater than eighty percent.
A higher LTV ratio indicates that the risk profile of a mortgage is higher. However, PMI is not only for lenders, it also enables borrowers to secure financing in cases where they can manage (or prefer) to deposit only 5% to 19.99% of the cost of the property or residence. Borrowers make payments of their monthly PMI until they have raised their share of equity in the home to the point that the lender no longer considers them high-risk.
PMI can cost you between 0.25% and 2% (generally the rate hovers around 0.5% to 1%) of the outstanding loan amount per year. The exact rate depends on the amount of your mortgage and down payment, your credit score and loan term. The riskier your credit profile, the higher the rate you pay. In addition, as PMI is a percentage of the amount of the loan, the more funds you borrow, the greater will be your PMI. In the US there are 6 major companies that provide PMI and their PMI rates are similar and are adjusted on an annual basis.
How long is PMI Carried?
Once the LTV of your mortgage drops to 78%, your lender is obligated by the federal Homeowners Protection Act to automatically terminate PMI, even in cases where the market value of your home has declined or depreciated. In other situations, the period of time you have to carry PMI varies depending on the kind of PMI you have chosen.
Types of PMI
There are 3 broad categories of PMI:
If you opt for this type of PMI, you will be paying a monthly premium until your PMI is either canceled at your request or it is terminated. PMI termination is triggered when your LTV balance reaches 78% of your home’s original value. If a borrower’s equity share in the home reaches 20%, he or she can send a notice to the lender requesting him to discontinue the PMI premiums.
Lenders must provide the buyers a written statement which notifies them the exact time it will take them to pay off twenty percent of the mortgage principal. The lender is under obligation to comply with this requirement as long as the value of your home hasn’t declined, you have made timely payments, and you are able to certify that you do not have a subordinate lien or second mortgage on your home.
Single Premium PMI
If you choose this type of PMI, you will make a single upfront mortgage insurance premium payment, which eliminates the need for a monthly PMI payment. You have the option of making this premium payment in full at closing or you can finance it into your mortgage. Although this option requires an upfront outlay, it can be beneficial for long-term homeowners.
In this case the lender pays PMI on behalf of the borrower. This can result in lower monthly mortgage payments, but you will usually pay a higher amount of interest over the loan term, as the rates tend to be higher for this kind of PMI. Also keep in mind that this type of PMI cannot be cancelled as it is a permanent part of the loan.
Cancellation of PMI
When you have buyer-paid PMI, it is vital to track your mortgage payments as well as your accumulated equity. The 78% threshold, at which automatic termination is triggered, depends on the date that your LTV is planned to reach 78% as per your amortization schedule, and not on the actual payments. It is important that you fully grasp this issue. It means that if you end up making extra payments and reach the 78% threshold in advance of your schedule, your lender is under no obligation to terminate PMI until the initial scheduled date. This can hurt you financially as you will end up making months or even years of unwanted PMI payments.
You should also not count on your lender to keep track of your equity valuation in the property. If your equity valuation has reached the limit of 20% of the original purchase cost, then it is your responsibility to request cancelation. For requesting cancellation, you will have to be current on your mortgage payments along with a good payment record.
However, paying off your mortgage is not the only means of building equity in your home, which allows you to request a cancelation. If you make minor improvements that add sufficient value to your property you can achieve the required minimum. For example, if you make major renovations, verify the numbers to check if you are now eligible for a written PMI cancelation request.
Factors that Affect Your PMI Rates
The rate you will eventually pay on your PMI depends on numerous factors which are listed below:
- The amount of the down payment – PMI cost has an inverse relationship with the amount of your down payment, meaning it will cost more if your down payment is low.
- Your credit score – The lower your credit score, the higher you will pay.
- Potential for Value Appreciation – if you happen to live in a market with appreciating home prices, your PMI premium may be lower.
- Type of loan. Mortgages which carry adjustable rates usually have greater PMI payments compared to fixed-rate mortgages.
For example, if you have a 30 year fixed mortgage worth $200,000 that carries an interest rate of 4.5%. Your aggregate monthly payment (sum of your interest and principal) will be $ 1,103. If your PMI rate is 0.5%, you will be paying an additional $1,000 yearly ($83.33 monthly), which will bring your monthly house payment up to $1,096.70.
Irrespective of the type you opt for, PMI is not cheap. However, there are a few ways to avoid it. As an alternative to PMI, you can use a second mortgage (also known as piggyback loan). By doing so, you take a first mortgage which is worth 80% of the property value and thereby avoid PMI and then secure a second mortgage of an amount that is equal to the sales price of your property after deducting the amount of the down payment and your first mortgage. But keep in mind that in most cases the interest rate applicable on your second mortgage will be higher compared to the first mortgage.
As a borrower you can get confused regarding whether to use a combination of first mortgage and PMI or use a second mortgage. This decision can be complex and can overwhelm most people who are not well-versed in finance. There are numerous factors that can play a part in this decision, like:
- Your monthly figures: Do the aggregate amount of your first and second mortgage payments exceed the aggregate amount of your first mortgage and PMI payments?
- The amount of tax savings on PMI payments compared to amount of tax savings on a second mortgage. US tax laws permit PMI deduction for specific income levels only. On the other hand, when it comes to regular mortgage interest there are usually no restrictions on deductions.
- What are the rates of principal reduction in case of each of these options?
- The time value of money.
But the most important factor is the anticipated rate of property price appreciation. Let us suppose a borrower opts for a stand-alone first mortgage along with PMI payments instead of using a second mortgage to eliminate PMI. The key question is how quickly the property value can appreciate to the point where the LTV is 78 % and thereby eliminate PMI? In most cases, this is the overriding variable.
The Difference between PMI and Mortgage Insurance Premium (MIP)
Speaking in strictly technical terms, PMI is only applicable to conventional loans. FHA loans tend to have their own specific mortgage insurance which has different requirements.
FHA loans and PMI loans have a few similarities as both require mortgage insurance to be paid by borrowers, in addition to regular mortgage payments. However, in case of mortgage insurance premium, you have to pay an up-front fee at closing along with monthly premiums for a given number of years; and this has to be paid to the U.S. Department of Housing and Urban Development (HUD) directly.
FHA loans are also different as they are accessible to borrowers with less-than-perfect credit, can’t be used for secondary residences or investments and permit down payments as little as 3.5 % of a property’s purchase cost.