Beforebuying a home, you should ideally save enough money for a 20% down payment.If you get a loan with a lower down payment, you will have to pay private mortgage insurance (PMI). The purpose of PMI is to protect the mortgage company if you default.
PMI provides a way to buy a house without having to use a large down payment. Sometimes it is the onlyoption for new homebuyers. However, there are many reasons to try to avoid PMI if possible. Learn more about those reasons as well as strategies for avoiding PMI.
Key Takeaways
- Private mortgage insurance (PMI) protects the mortgage company if you default.
- PMI adds significant expense to a mortgage payment.
- Mortgage insurance premiums are not tax deductible.
- In some circ*mstances, PMI can be avoided by usinga piggyback second mortgage.
Six Reasons to Avoid Private Mortgage Insurance (PMI)
1. Cost
The total costs of PMI over the life of the mortgage can be substantial. PMI typically costs between 0.5% to 1% of the entire loan amount on an annual basis. That means, for example, you could pay as much as $1,000 a year—or $83.33 per month—on a $100,000 loan, assuming a 1% PMI fee. The amount will vary based on your credit score and loan-to-value ratio.
Paying PMI can be more costly than paying interest on a piggyback second mortgage, which can be used in lieu of a cash down payment. Saving would depend on factors like the terms of the loans and cost of PMI.
2. Not Deductible
Up until 2017, PMI was still tax-deductible,but only if a married taxpayer’s adjusted gross income wasless than $110,000per year.The 2017 Tax Cuts and Jobs Act (TCJA)ended the deduction for mortgage insurance premiums entirely, effective 2018. PMI was deductible during the COVID-19 pandemic, but it is no longer deductible.
3. Your Heirs Do Not Benefit
The lending institution is the sole beneficiary of a mortgage insurance policy, and the proceeds are paid directly to the lender (not indirectly to the heirs). If you want to protect your heirs and provide them with money and a home upon your death, you’ll need to obtain a separate insurance policy. PMI will not provide financial protection to anyone but your mortgage lender.
4. Lost Investing Opportunity
Homebuyers who put down less than 20% of the sale price will have to pay PMI until the total equity of the home reaches 20%. This could take years, and it amounts to a lot of money you pay to protect the lender without a benefit to yourself.
Money spent on PMI could have been invested and earned profits. For example, if a couple who owns a $250,000 home were to instead take the $208 per month they were spending on PMI and invest it in a mutual fund that earned an 8% annual compounded rate of return, that money would grow to $37,707 (assuming no taxes were taken out) within 10 years.
5. Difficult to Cancel
Usually when your equity tops 20%, you no longer have to pay PMI for conventional mortgages. However, eliminating the monthly expense isn’t as easy as just not sending in the payment. Many lenders require you to write a letter requesting that the PMI be canceled. They may require a formal appraisal of the home. This could take several months, depending upon the lender, during which time PMI still has to be paid.
For some types of loans, like FHA loans, you cannot cancel mortgage insurance. Instead, to remove the mortgage insurance costs, you must refinance the loan or pay it down fully.
The Consumer Financial Protection Bureau (CFPB) recently found cases of bogus PMI charges are among they types ofjunk fees that can occur. Be aware of mortgage servicers including a private mortgage insurance premium when one is not required.
6. Payment Is Ongoing
One final issue that deserves mentioning is that some lenders require you to maintain a PMI contract for a designated period. So, even if you have met the 20% threshold, you may still be obligated to keep paying for the mortgage insurance. Read the fine print of yourPMI contract to determine if this is the case for you. PMI isn’t automatically canceled until your equity hits 22%.
How to Avoid Paying PMI
In some circ*mstances, PMI can be avoided by usinga piggyback mortgage. It works by using two mortgages so that neither mortgage provides for more than 80% of the value of the home.
For example, if you want to purchase a house for $200,000 butonly have enough money saved for a 10% down payment, you can enter into what is known as an 80/10/10agreement. You will take out one loan totaling 80% of the total value of the property, or $160,000, and then a second loan, referred to as a piggyback, for$20,000 (or 10% of the value). Finally, as part of the transaction, you put down the final 10%, or $20,000, in cash.
By splitting up the loans, you may be able to deduct the interest on both of them and avoid PMI altogether. Of course, there is a catch. Very often the terms of apiggyback loan are risky. Many are adjustable-rate loans,contain balloon provisions, orare due in 15 or 20 years (as opposed to the more standard 30-year mortgage).
How Can I Avoid Paying PMI?
You can avoid paying PMI by providing a down payment of more than 20% when you take out a mortgage. Mortgages with down payments of less than 20% will require PMI until you build up a loan-to-value ratio of at least 80%. You can also avoid paying PMI by using two mortgages, or a piggyback second mortgage.
What Is a Piggyback Mortgage?
A piggyback mortgage is a second mortgage used to fulfill the down payment requirements so that the homebuyer does not have to pay private mortgage insurance (PMI). The buyer will hold two mortgages instead of one, and they may have different interest rates.
Can You Remove PMI on FHA Loans?
If you have private mortgage insurance (PMI) included on your FHA loan, you cannot remove it if you closed the loan after June 3, 2013. To remove PMI on an FHA loan, you must either pay the loan back in full or refinance the loan.
The Bottom Line
PMI is expensive. Unless you think you can get 20% equity in the home within a couple of years, it probably makes sense to wait until you canmake a larger down payment or consider a less expensive home, which will make a 20% down payment more affordable. If you are buying a home and have a small down payment amount, consider consulting a financial advisor or mortgage professional to review the options that best fit your situation.
