Understanding private mortgage insurance (PMI) and how to avoid paying it
What you need to know about PMI before buying a home
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When you’re in the process of budgeting for a new home purchase, there are numerous terms and costs to be aware of, and one of them is Private Mortgage Insurance (PMI).
While PMI is a significant expense that can cost homeowners hundreds of dollars a month on top of their mortgage, it also allows borrowers who do not have a substantial down payment saved (or choose not to use their savings) to access the housing marketing, making homeownership more attainable.
In this article, we'll delve into what PMI is, why it exists, and strategies to avoid paying it.
What is private mortgage insurance (PMI)?
Private Mortgage Insurance, commonly referred to as PMI, is a type of insurance that lenders often require from borrowers who make a down payment of less than 20% of the home's purchase price. The primary purpose of PMI is to protect the lender in case the borrower defaults on the mortgage.
Why do lenders require PMI?
Lenders require PMI for two main reasons:
Risk Mitigation: When a borrower makes a smaller down payment, the lender assumes a higher risk. PMI helps offset this risk by providing financial protection to the lender in the event of foreclosure.
Low Down payment: When a borrower wants/needs to put less than 20% down on their house purchase.
How much will I be charged for PMI?
To calculate your annual PMI payment, you'll need to know the specific PMI rate for your loan. This figure usually shows up as an annual percentage rate (APR).
Your PMI rate will depend on several factors, but you can generally expect to pay between 0.5% and 1.5% of the amount you’re borrowing.
Hypothetically, if someone took out a $750,000 loan with a PMI rate of 1%, you would multiply the loan amount by .01 for a total annual PMI payment of $7,500, or $625 a month.
Factors that determine the cost of your PMI
The cost of Private Mortgage Insurance (PMI) can vary depending on several factors, including the size of your down payment, your credit score, and the type of mortgage you have. These factors include:
Down payment percentage
The size of your down payment is a significant factor in determining the cost of PMI. Generally, the smaller your down payment, the higher your PMI premiums will be. For example, if you make a down payment of 3% to 5%, your PMI costs will likely be higher compared to making a 10% or 15% down payment.
Your credit score can also affect the cost of PMI. Borrowers with higher credit scores may be eligible for lower PMI rates, while those with lower credit scores may face higher premiums.
The type of mortgage you have can impact your PMI costs. For example, loans insured by the Federal Housing Administration (FHA) have their own mortgage insurance premiums, which are structured differently from traditional PMI. VA loans for veterans and active-duty military personnel do not require PMI.
The size of your mortgage loan also plays a role. A larger loan amount will result in higher PMI premiums.
PMI can be paid in different ways, which can affect the cost. Some borrowers pay PMI monthly as part of their mortgage payment, while others may choose to pay it upfront as a lump sum or through a combination of upfront and monthly payments.
Lender and market factors
PMI rates can vary among different lenders and may also be influenced by market conditions. It's a good idea to shop around and compare quotes from various lenders to find the best PMI rate for your situation.
How to avoid paying PMI
Make a 20% down payment:
The most straightforward way to avoid PMI is to make a down payment of at least 20% of the home's purchase price. By doing so, you demonstrate to the lender that you have a significant stake in the property, reducing the need for insurance.
Refinance when you reach 20% equity
If you're already paying PMI, keep track of your mortgage balance. Once you've reached 20% equity in your home, consider refinancing to remove PMI from your monthly payments.
Improve your credit score
A higher credit score can make you eligible for better mortgage terms, potentially reducing or eliminating the need for PMI. Work on improving your credit by paying bills on time, reducing debt, and addressing any inaccuracies in your credit report.
Consider lender-paid PMI (LPMI)
Some lenders offer a variation of PMI called Lender-Paid PMI. With LPMI, the lender pays for the PMI upfront in exchange for a slightly higher interest rate on your mortgage. While this may seem like you're still paying for PMI, the advantage is that the interest on your mortgage is tax-deductible, unlike PMI premiums.
Look into piggyback loans
A piggyback loan involves taking out two separate loans simultaneously. The first loan covers 80% of the home's purchase price, allowing you to avoid PMI, and the second loan (a smaller one) covers the remaining amount. These loans can be a complex option, so it's essential to consult with a financial advisor to determine if it's the right choice for you.
Private Mortgage Insurance (PMI) can add a significant cost to homeownership, but there are ways to avoid or reduce this expense. By making a substantial down payment, exploring alternative loan options, and working on your credit score, you can take steps toward a more financially advantageous home purchase.
It's essential to discuss your specific situation with a mortgage professional to determine the best strategy for avoiding PMI.