PMI 101: What You Need to Know About Private Mortgage Insurance
May 30, 2023
7 min read
Purchasing a home is no small feat—it's a major investment that requires careful consideration and planning. It's an exciting milestone but can also be overwhelming, especially when understanding the financial aspects.
One of the most crucial financial considerations for homebuyers is Private Mortgage Insurance (PMI). PMI is often misunderstood but can significantly impact your monthly mortgage payments and homeownership costs.
What Is Private Mortgage Insurance (PMI)?
In the event that a borrower's down payment is lower than 20% of a home's total value, lenders will often mandate the purchase of Private Mortgage Insurance (PMI) as a type of insurance policy. It's designed to protect the lender if the borrower defaults. PMI is usually required for conventional loans but may also be required for government-backed loans, such as Federal Housing Administration (FHA) and Veteran Affairs (VA).
The purpose of PMI is to reduce the risk that lenders face when lending money to borrowers with a low down payment. The insurance policy covers the lender's losses in case the borrower defaults on the loan. The cost of PMI is typically added to the borrower's monthly mortgage payment, increasing the total homeownership cost.
What Are the Different Types of PMI?
Understanding private mortgage insurance (PMI) is important when considering a home loan. Several PMI types are available, each offering different benefits and drawbacks.
1. Borrower-Paid Mortgage Insurance (BPMI)
BPMI is the most commonly used type of PMI. With this type of PMI, the borrower pays a monthly premium included in their mortgage payment. BPMI costs vary based on several factors, including the down payment size, the loan amount, and the borrower's credit score. In most cases, the PMI premium is a percentage of the loan amount.
2. Lender-Paid Mortgage Insurance (LPMI)
LPMI is less common than BPMI. With LPMI, the lender pays the insurance premium, and the cost is factored into the borrower's interest rate. In exchange for the lender paying the PMI premium, the borrower typically receives a lower interest rate than they would with BPMI. However, this lower interest rate may not always be the best option for borrowers, as it can result in higher overall mortgage costs in the long run.
3. Single Premium Mortgage Insurance (SPMI)
SPMI involves paying a lump sum upfront for the insurance policy. The lump sum can be paid in cash or into the mortgage loan. The advantage of SPMI is that it avoids the need for monthly PMI payments. However, the upfront cost of SPMI can be substantial, and it may not be the best option for all borrowers.
When Is PMI Required?
Usually, borrowers are required to obtain Private Mortgage Insurance (PMI) when their down payment is below 20% of the home's value. However, there are some exceptions based on the type of loan a borrower has.
1. Conventional Loans and PMI
PMI is typically required for conventional loans, which are loans that are not guaranteed or insured by the federal government. For conventional loans, the amount of PMI required is based on the loan-to-value (LTV) ratio, which is the loan amount divided by the property's appraised value. The higher the LTV, the higher the PMI premium.
2. Federal Housing Administration (FHA) Loans and PMI
FHA loan guarantees come from the Federal Housing Administration, which operates under the U.S. Department of Housing and Urban Development. With an FHA loan, PMI is required regardless of the down payment amount. The PMI premium for an FHA loan is called a Mortgage Insurance Premium (MIP) and is divided into an upfront premium, paid at closing, and an annual premium paid monthly.
3. Veteran Affairs (VA) Loans and PMI
VA loans are supported by the U.S. Department of Veteran Affairs and can be obtained by eligible veterans, active-duty military personnel, and their spouses. With a VA loan, PMI is not required, even if the borrower makes a down payment of less than 20% of the home's value. However, the borrower may be required to pay a funding fee, which is a one-time fee that helps offset the cost of the VA loan program.
How Much Does PMI Cost
PMI's cost is variable and dependent on several factors, such as the loan amount, down payment amount, loan term, and the borrower's credit score.
Factors that Determine PMI Cost
The primary factor determining PMI cost is the loan-to-value (LTV) ratio, which is the loan amount divided by the property's appraised value. The higher the LTV ratio, the steeper the PMI premium. Other factors affecting PMI cost include loan duration, borrower credit score, and down payment amount.
How to Calculate PMI
PMI is typically calculated as a percentage of the loan amount, with the percentage based on the LTV ratio. For example, if the LTV ratio is 90%, the annual PMI premium might be 0.5% of the loan amount. To calculate the PMI premium for a specific loan, borrowers can use online calculators or consult with their lender.
It's important to note that PMI is usually added to the borrower's monthly mortgage payment, increasing the total homeownership cost. However, the cost of PMI can decrease over time as the borrower pays down their mortgage and their LTV ratio decreases. Once the LTV ratio reaches 80%, the borrower may be able to request cancellation of their PMI policy.
What Are the Benefits and Drawbacks of PMI?
Private Mortgage Insurance (PMI) can help make homeownership more accessible to borrowers who can't afford a 20% down payment. However, PMI also comes with both advantages and disadvantages.
Advantages of PMI
- It enables borrowers to purchase a home with a low down payment. PMI makes it possible for borrowers to purchase a home with a down payment of less than 20%, which can benefit those who may not have enough money saved for a larger down payment.
- It can help borrowers qualify for a loan. PMI can help borrowers qualify for a mortgage loan they might not otherwise be eligible for because of a low down payment.
- It may be tax-deductible. In some cases, the PMI premium may be tax-deductible, which can help reduce the overall cost of homeownership.
Disadvantages of PMI
- It adds to the cost of homeownership. PMI is an added expense that increases the overall cost of homeownership. The cost of PMI can be substantial, especially for borrowers with a low down payment.
- It only benefits the lender. PMI only protects the lender, not the borrower. If the borrower defaults on their loan and the property is foreclosed, the PMI policy will reimburse the lender for their losses. However, the borrower will still be responsible for any remaining balance on the loan.
- It may be difficult to cancel. Canceling PMI can be complicated, and some borrowers may be stuck paying the premium for the life of the loan.
How to Avoid PMI
Private Mortgage Insurance (PMI) can add a high cost to homeownership. Fortunately, there are several ways to avoid PMI.
- Make a larger down payment. Borrowers can steer clear of PMI by making a down payment of at least 20% of the home's value.
- Piggyback loans. This option involves taking out a second mortgage to cover the down payment, allowing the borrower to avoid PMI. For example, a borrower could take out a first mortgage for 80% of the home's value and a piggyback loan for the remaining 20%.
- Lender-paid Mortgage Insurance (LPMI). With LPMI, the lender pays for the insurance policy, which is factored into the borrower's interest rate. This can be beneficial for those who do not want to pay a larger down payment but need to bypass PMI.
- VA Loans. VA loans do not require PMI, even if the borrower makes a down payment of less than 20%. However, VA loans are only available to eligible veterans, active-duty service members, and spouses.
Weighing each option's advantages and disadvantages is essential to determine which one best suits your financial standing and objectives for owning a home.
Take Control of Your Home Buying Process
Private mortgage insurance (PMI) is a useful tool for those looking to purchase a home but don't have the money for a 20% down payment. It can help you get into a house sooner, but it does come with associated costs and risks that must be considered. Researching the different types of PMI available, as well as other alternatives, will help you make an informed decision about whether PMI is right for you and your financial situation.
