If you’re on the hunt for your first home, and plan on putting down less than 20 percent, you’ll need to get familiar with the concept of private mortgage insurance (PMI). While many consumers have heard of PMI, there are several misconceptions about how the process works. Let’s take a look at the basics and, hopefully, clear up some of the confusion.
Before diving in, it’s important to mention that we are talking about conventional loans. Government-backed loan programs have components similar to PMI, but this is set up a bit differently, and that’s a topic for a different day.
What exactly is PMI?
Lenders require PMI when a first mortgage’s loan-to-value ratio is greater than 80 percent — that’s industry speak for “less than 20 percent down.” Why do they do this? Well, the less a borrower puts down, the higher the risk they are to the lender. PMI serves as protection for the lender’s investment, should the borrower default on the mortgage.
PMI is provided by private mortgage insurance companies. Some lenders have one specific company they work with, while others have several different providers they call on for quotes.
How is it calculated?
Typical PMI rates run about 0.5 to 1 percent of your loan balance per year, but it could be a bit higher or lower. Joe Sambaer, senior mortgage banker with Dart Bank, says there are a few different factors that determine each borrower’s rate.
“First we look at the amount of the down payment,” he said. “The higher the down payment — 3, 5, 10, or 15 percent — the lower the mortgage insurance.”
In addition to down payment, lenders also look at the borrower’s credit score and debt-to-income ratio.
“There used to be a set amount for PMI, but there is much more analysis done today,” said Sambaer. “I could have two clients with a $100,000 loan and one might pay $35 a month in PMI, while the other could pay $100 a month. It really depends on each buyer’s situation.”
How is PMI paid?
There are actually a couple of different ways PMI can be paid. Sambaer says there is the traditional method, in which the borrower pays a monthly mortgage premium, but he says PMI can also be paid up front.
“If you choose the single-payment mortgage insurance option, the total PMI is paid at closing in one lump sum,” he said. “Either the borrower will pay it themselves, the seller may agree to pay it, or sometimes buyers can pay a bit higher interest rate in exchange for the lender covering the payment.”
How long do I have to pay PMI?
If you’re required to carry PMI with a down payment of less than 20 percent, it would seem that you could cancel PMI once you reach 80 percent loan-to-value, but Sambaer says things change a bit after closing.
“PMI falls off automatically once the borrower reaches 22 percent equity, or 78 percent loan-to-value,” he said. “If you look at your amortization schedule, there is a date listed in which the insurance will be cancelled without you needing to do anything.”
Let’s say after living in your home for a year or two, you have access to some extra cash. You might consider paying down your mortgage principal in order to get rid of PMI even earlier, but anyone considering this option should first talk with their lender.
“In this situation, it’s not an automatic removal,” said Sambaer. “The mortgage servicer will do their due diligence to check the home’s current property value and ensure the extra principal payment would bring the loan-to-value ratio down enough. When you do it this way, the ratio must be at least 80 percent.”
A few years back when the market was still in a decline, Sambaer had a client who, without consulting him first, made a significant payment on his principal in an effort to remove PMI. Once the property valuation was done, the home was actually found to be worth less than when it was purchased, and the borrower’s large payment did not, in fact, bring down the loan-to-value ratio enough to remove PMI.
“Had the homeowner known that ahead of time, they may have made a different decision,” said Sambaer. “Things like this don’t happen often, but before you make any big decision about your mortgage, it’s always a good idea to check with your lender.”
A homeowner may also be able to remove PMI with a refinance. A lower interest rate and a potential increase in home value may be enough to remove that insurance payment, but again, this would need to be discussed with your mortgage service provider.