What Is Private Mortgage Insurance?
If you’re a first-time homebuyer looking to take advantage of historically low-interest rates, there are a lot of fees to keep your eye on as you work to stay within your budget. While you can shop around for a lower insurance policy and closing costs can vary based on who you choose as your real estate attorney or titling company, there are some aspects of your home purchase that might be non-negotiable. For example, a lower credit score could mean a higher interest rate, even if you have a great income as a borrower.
One of the biggest financial decisions you’ll make when purchasing a home is how much of a down payment to put down. Conventional wisdom for homebuyers is to put down 20% of the appraised value on a home since this avoids you needing to take out something called private mortgage insurance, or PMI. That being said, private mortgage insurance isn’t always a bad thing—it mostly depends on your personal finances and situation. Learn more about the ins and outs of PMI below, along with how to get rid of it.
What is private mortgage insurance (PMI)?
Commonly abbreviated as PMI, private mortgage insurance is a type of insurance that protects the bank or mortgage lender giving homeowners a mortgage. It is not homeowners' insurance.
How does PMI work?
How it works is PMI ensures that in the case of a foreclosure, the lender isn’t on the hook for the full loan amount of the home’s purchase price, since you’ve been giving them extra payments at a certain private mortgage insurance rate in exchange for them taking on more risk with your loan.
While PMI is money you never get back (since it doesn’t go towards paying down the principal or interest on your loan), that doesn’t mean that you should do everything in your power to avoid PMI on a loan. If you live in a high cost of living area, you might find that compared to renting, purchasing a condo or home may still be cheaper, even when you factor in the added cost of PMI. This is one reason that lower interest rates are making it more attractive to get into homeownership since they help mitigate the negative impact of PMI.
As you shop around for different loan estimates, make sure to ask lenders what their policies are regarding PMI and how to pay it.
Usually, PMI premiums can be paid in a few different ways:
PMI as an annual premium
The most common way you’ll pay PMI is with your monthly mortgage payment on an annual basis. Generally speaking, this amount can range from between .5% and 1% of the original value of your loan, divided across 12 months.
PMI as an upfront premium
Another way you may decide to pay for PMI is as an upfront premium. In this scenario, rather than paying out PMI each month, you pay it all in one lump sum upfront. This amount varies from lender to lender but is usually a percentage of the price of the house itself. Paying PMI upfront could make sense if you know you plan on staying in the house for a long time; however, since that percentage could also be put to work increasing your downpayment (and with it, your home equity), this scenario isn’t for everyone.
'Lender paid' PMI
Some lenders offer PMI over the life of the loan through something called “lender paid” PMI. While this might sound attractive, you’re actually still the one footing the bill for the PMI in this scenario. Usually, in order to qualify for lender-paid PMI, you’re taking a higher interest rate than you’d otherwise receive, which can add thousands to your home costs over the next 30 years.
Who is required to have a PMI?
When it comes to taking out a loan from a lender, your downpayment in relation to the value of your home plays a big role in determining whether you’ll have PMI payments to make. Of course, if your down payment is less than 20%, you’ll almost always have to pay PMI in some way, shape, or form.
However, there are a few instances where you might owe PMI even if you have a larger downpayment. For example, if you have 20% to put down towards the home, and the property appraises at the same value as the purchase price, you’re in the clear. However, if the appraisal value skews lower than the purchase price, you may need to take out PMI or cough up more cash to cover the difference and mitigate risk for your lender.
It’s also worth remembering that different lenders offer different types of mortgage products, and not all of them handle PMI the same way. As such, whether you’re looking to take out a mortgage with Freddie Mac or are comparing fixed-rate mortgages with local brokerages, it’s crucial to understand how they structure their private mortgage insurance if you know you’ll be putting less than 20% down towards your home. Here are two of the most common types of loans and how PMI is generally handled in these scenarios:
In order to qualify for a conventional loan, you’ll almost always need to put down at least 5% towards your purchase. If you don’t have 20%, you’ll need to take out PMI—but you might be able to get rid of it depending on the terms you agree to.
The Federal Housing Administration, also known as the FHA, offers a variety of loans and programs designed to help first-time homebuyers start building equity and get into their own house. FHA loans can be taken out with a much lower down payment (usually at least 3.5%) and may also come with other assistance to help with closing costs. FHA loans come with mortgage insurance premiums, commonly abbreviated to MIP, which is the FHA’s form of private mortgage insurance. Although it has a different name, it’s functionally the same as PMI; it just applies to FHA loans instead of conventional mortgages.
How to get rid of PMI
There’s a common misconception that PMI is for the lifetime of the loan; however, as long as you haven’t chosen a lender-paid PMI option, you may be eligible to get out of PMI through refinancing to another lender or meeting other requirements.
For example, some lenders automatically offer PMI cancellation when the loan-to-value ratio of your loan reaches a certain threshold—often when your principal is paid down to 80% of the original purchase price. If you’re looking for a quick way to cash-out and cancel your PMI, you may be able to get to that 80% LTV ratio sooner if your home appraises at a higher value which boosts your equity.
If you know that you’re going to want to get out of your PMI as quickly as possible, make sure that your loan provider allows you to do so and what their guidelines are. It’s also critical that you ensure that your lender will allow you to pay down your principal aggressively, since some mortgages cap how much extra you can pay towards the principal each year.
The bottom line
With mortgage rates as low as they are, having a down payment of less than 20% may require you to pay private mortgage insurance, but it likely won’t set you back too much. Remember that not everyone has the means to save up a 20% downpayment—in fact, the median downpayment of first-time homebuyers in 2019 was only 6% according to the National Association of Realtors.
While it’s true that PMI is money you don’t get back, if you view PMI as a small fee to get into homeownership sooner, it becomes much easier to stomach. Especially if you live in an expensive area of the country and want to take advantage of low-interest rates this year, PMI may be necessary in order to get into homeownership sooner. Just make sure to talk to your lender about what sorts of requirements there are to eliminate PMI so you know that option is open after you close on your new home.