Private Mortgage Insurance 101

The 411 on PMI

Private Mortgage Insurance 101
May 12, 2014

Private Mortgage Insurance, or PMI, is a form of insurance you pay when buying a home to mitigate the default risk that you pose to the lender. PMI is called "private" to distinguish it from government-backed mortgage insurance that is required with FHA loans or VA loans.

Generally, PMI is required on any home purchase where the down payment is less than 20% of the value of the home. If you have less than 20% equity in the house, you are automatically considered higher risk by the lender.

Lenders procure PMI through a third party and pass the costs on to you. Your PMI can be paid for in several ways, although a typical method is to include them in the monthly mortgage payments. They can be paid in part or in total with a lump sum up front, or they can be financed as part of the overall loan package.

The cost of PMI varies, but it will be proportionate to the risk you pose. The lower your credit score, and the higher your loan amount and LTV (Loan-to-Value) ratio, the higher your premiums will be. The type of loan you have will also play a role.

Costs are calculated as a percentage of the overall loan amount. A typical monthly premium may be anywhere from $30-$100 per $100,000 of money borrowed.

Normally, PMI payments are normally required until you have built up a 20% equity value in the house. Loans that are considered extremely high-risk may require a longer payment period. Once you finally reach the 20% equity mark, you can ask that the lender cancel the PMI – for many loans they are obligated to cancel at 22%.

At the loan's closing, your lender is required to tell you when you will reach the 20% equity mark, assuming that you make your payments on schedule with no prepayments. Keep in mind that you are primarily paying interest in the early years, and it takes time to build equity to the 20% mark – especially if you are starting with less than 10% equity based on a low down payment.

However, there is another way to look at this – LTV ratio. Your LTV ratio is the outstanding loan amount over the value of your home, which changes over time through appreciation or depreciation. If the value of your home rises, the LTV ratio drops.

You can also think of it this way – the amount you own is the total of the principal portion of the payments you have made so far, plus the amount that your house has appreciated.

Theoretically, your PMI could end up being cancelled ahead of your original schedule for this reason – although you will need an appraisal to prove to the lender that the value of your house has risen. You will have to calculate whether the cost of an appraisal is worth the savings in PMI that you would receive from an early cancellation. (Of course, this could work in reverse if the value of your house has fallen.)

There are several PMI and mortgage calculators online to help you test different scenarios of down payments versus the difference in PMI. Since rates can differ, the PMI calculations will be estimates.

PMI can help you buy more house than you would normally be able to afford with your down payment. Only you can decide if that is a good thing, or if you are buying more house than you can afford.


Photo ©iStock.com/freemixer

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