Private mortgage insurance (PMI) is an insurance policy that protects lenders from the risk of default and foreclosure. Generally, if you need financing to buy a home and make a down payment of less than 20% of the home's cost, your lender will require you to buy insurance from a PMI company prior to signing off on the loan. Although it costs extra, PMI allows buyers who cannot make a significant down payment (or those who choose not to) to obtain financing at affordable rates.
Key Takeaways
- Private mortgage insurance (PMI) is incurred if you need to finance more than 80% of the purchase price of a home.
- You can avoid PMI by simultaneously taking out a first and second mortgage on the home so that no one loan constitutes more than 80% of its cost.
- You can opt for lender-paid mortgage insurance (LMPI), though this often increases the interest rate on your mortgage.
- You can request the cancellation of PMI payments once you have built up at least a 20% equity stake in the home.
Understanding Private Mortgage Insurance
PMI is a financial safeguard required by lenders when homebuyers make a down payment of less than 20% on a conventional mortgage. The purpose of PMI is to protect the lender in the event of default by the borrower, as a smaller down payment increases the risk for the lender.
While PMI allows borrowers to obtain a mortgage with a lower initial down payment, it does add an extra cost to their monthly mortgage payment, which can significantly impact their overall housing expenses. For this reason, many buyers strive to avoid having to pay PMI as that additional cost, regardless of how small, could instead be applied to principal payments or other investments.
According to the Texas Department of Insurance, PMI will vary from borrower to borrower and can cost between 0.5% and 6.0% of the original loan amount annually.
How to Avoid PMI
Achieve Loan-to-Value of 80%
One way to avoid paying PMI is to make a down payment that is equal to at least one-fifth of the purchase price of the home; in mortgage-speak, that means the mortgage's loan-to-value (LTV) ratio is 80%. If your new home costs $180,000, for example, you would need to put down at least $36,000 to avoid paying PMI. While that's the simplest way to avoid PMI, a down payment that size may not be feasible.
Invest in Highly Appreciable Property
If the value of your home has appreciated to an amount that drops your LTV below 80%, some banks will allow you to submit a request to cancel PMI.However, in this scenario, it is likely that the bank would require a professional appraisal to accompany the request, the cost of which is assumed by the borrower. In addition, be mindful that real estate valuations may not materially increase in a very short period of time; the primary way this may be achieved is if a substantial down payment is still made.
Secure a Piggyback Mortgage
Another option for qualified borrowers is a piggyback mortgage. In this situation, a second mortgage or home equity loan is taken out at the same time as the first mortgage. With an "80-10-10" piggyback mortgage, for example, 80% of the purchase price is covered by the first mortgage, 10% is covered by the second loan, and the final 10% is covered by your down payment. This lowers the loan-to-value (LTV) of the first mortgage to under 80%, eliminating the need for PMI. For example, if your new home costs $180,000, your first mortgage would be $144,000, the second mortgage would be $18,000, and your down payment would be $18,000.
Get Lender-Paid Mortgage Insurance
A final option is lender-paid mortgage insurance (LMPI) where the cost of the PMI is included in the mortgage interest rate for the life of the loan. Therefore, you may end up paying more in interest over the life of the loan. Though this technically avoids PMI, you'll still be paying for additional new costs, so it has the same effect of raising your monthly payment requirement indirectly.
Enter Government-Backed Loan
Government-backed loans, such as Federal Housing Administration (FHA) loans or Veterans Affairs (VA) loans, often have lower down payment requirements and may not require PMI. However, these loans have their own eligibility criteria and may have other fees. Similar to lender-paid mortgage insurance, you may avoid PMI but see other indirect or soft costs increase.
Be mindful of the overall financial implications of avoiding PMI; you may end up paying more in other fees or charges to avoid the insurance cost.
Pay Lump-Sum PMI
Some lenders may allow you to pay for PMI upfront in a single lump sum rather than as a monthly premium. While it requires a larger upfront payment, it can save you money over time compared to paying PMI monthly due to the time value of money. For instance, some lenders would prefer to have a discounted amount of capital upfront using a discount rate.
Ending PMI Early
Once you've had your mortgage for a few years, you may be able to get rid of PMI by refinancing—that is, replacing your current loan with a new one—though you’ll have to weigh the cost of refinancing against the costs of continuing to pay mortgage insurance premiums. You may also be able to ditch it early by prepaying your mortgage principal so that you have at least 20% equity (ownership) in your home. Once you have that amount of equity built up, you can request the lender cancel your PMI.
Assuming you stay current with your mortgage payments, PMI does eventually end in most cases. Once the mortgage's LTV ratio drops to 78%—meaning your down payment, plus the loan principal you’ve paid off, equals 22% of the home’s purchase price—the federal Homeowners Protection Act requires the lender to automatically cancel the insurance.
Can I Refinance to Eliminate PMI?
Yes, you can refinance your mortgage to a loan with a higher equity percentage, which can help eliminate the PMI requirement. For instance, if you originally financed with a 5% down payment, you could refinance when your home equity reaches 20%, effectively removing the PMI.
Can PMI Rates Change Over Time?
PMI rates are generally fixed at the time of obtaining the mortgage and remain constant throughout the loan term. However, lender-paid PMI programs may involve varying interest rates, depending on the specific terms and conditions offered by the lender.
Are All Mortgages Subject to PMI?
No; PMI is typically required for conventional mortgages with a down payment of less than 20%. Government-backed loans like FHA and VA loans have their own insurance requirements such as FHA mortgage insurance premiums or VA funding fees. Note that these additional costs may function differently from traditional PMI.
How Long Do I Have to Keep PMI?
The duration of PMI varies, but you typically must keep it until you reach a certain loan-to-value (LTV) ratio or have paid off enough of the mortgage to eliminate the requirement. Most lenders follow guidelines that allow you to request PMI cancellation once your LTV reaches 80% or less. Additionally, if your home's value increases due to market appreciation or home improvements, you may be able to request early cancellation of PMI.
The Bottom Line
Private mortgage insurance is a type of insurance required by lenders when a borrower makes a down payment of less than 20% on a conventional home loan. Its purpose is to protect the lender in case the borrower defaults on the loan, reducing the lender's financial risk. Borrowers can explore various strategies such as making a 20% down payment, seeking government-backed loans, or opting for lender-paid PMI to avoid paying PMI and reduce their overall mortgage costs.
