What is PMI?
If you’ve started looking for a home, chances are, you’ve heard the term “PMI”. PMI stands for Private Mortgage Insurance and simply put, it’s insurance you pay to protect the lender. Unlike normal insurance, you’re paying the premium to protect someone else, which causes part of the confusion. So why does PMI exist? PMI is there for a very important reason, to provide a way that you can become a homeowner without a 20% down payment.
A practical example of PMI
Let’s say you are purchasing a home for $200,000 and you put 20% down, or $40,000. Down the road, if you miss your payments and the bank forecloses, they have enough security (your original down-payment) in the property to cover things like missed payments, repairs, and re-selling the property. Now let’s say that you are purchasing a home for $200,000 and you are putting 3.5% down, or $7,000. In the same foreclosure situation, the bank may end up with a loss if they only have $7,000 to cover the missed payments, repairs and resale. And it comes as no surprise, lenders don’t like to lose money!
Use PMI to your advantage
The great news is that PMI provides an option (that doesn’t involve the bank declining your application!) for you to become a homeowner without 20% down. As the homeowner, you pay the premium, but in case of a default, it covers the lender for the reasons above. So instead of asking, “Do I have to pay PMI”, the better question may be, “Can I use PMI to become a homeowner faster?”
If you do end up with PMI, you can pay it through your normal monthly mortgage payment. This makes it easy to budget for and helps you avoid another upfront cost at closing. You should work with your mortgage broker or chosen lender to understand what your total payment would be with the loan, escrow (for things like insurance and taxes) and PMI before committing to your mortgage.
When is PMI NOT required?
So perhaps you’re convinced PMI is useful in some situations, but you’d really like to know how to avoid it. Are you really required to pay PMI in all cases? No, here are the types of buyers that can typically avoid PMI:
Buyers with a down-payment of 20% (or more) who are using a conventional loan – The larger down-payment serves as protection for the lender which means PMI is off the table.
Buyers who are eligible for an FHA or VA loan – Both of these loan types have different pros and cons when compared to a traditional lender – one benefit being that they don’t require PMI. However, there are other fees that are similar and may be more expensive in the long run. At the end of the day, the less down payment you put down, the more likely you’ll have some costs to help offset the risk to the lender. Be sure to keep that in mind when comparing all your options.
How much does PMI cost?
At this point, you may be wondering how much PMI typically costs. Plan for between .03 percent and 1.5 percent of your total loan amount. Where you fall in that range depends on a number of factors – items that lenders look at to calculate your risk. You’re probably already familiar with a number of these factors because they’re the same factors that come into play when applying for a mortgage. The list below is not comprehensive but are some good things to keep in mind when trying to improve what PMI rate you may have to pay:
- Your down payment – the higher you pay here, the less you pay for PMI.
- Your credit score – as with most lending situations, a higher credit score is interpreted as a lower risk.
- Total loan amount – think about it this way, if you loan your friend $10, your risk is lower and you may have more faith (or security) that you’ll be able to collect. But loaning your friend $10,000 may make you a little more worried – the same is true with any lender. A $200,000 home carries a different risk factor than a $500,000 home.
- Interest rate – in some cases, paying a higher interest rate may reduce the amount of PMI you have to pay. This varies by lender so remember to investigate each option before committing to any mortgage.
PMI is only temporary
We’ve covered why you have to pay PMI and how a larger down payment can help you avoid it, but let’s talk about what to do once you have it. If you chose to use PMI, the good news is you likely got into a home much faster than you may have otherwise, but it doesn’t mean you’re stuck with it for life! Let’s talk about how soon you can get rid of PMI (and lower your monthly payment) once you have it.
The 20% magic number
Once you reach 20% equity (meaning you’ve paid 20% of your total home value), PMI is not required. You may hear 20% and think of that original down-payment but that’s not the only option. At any point, the lender can be protected by reaching the 20% equity mark, which means you can stop paying PMI. Instead of an initial down-payment, you can reach 20% over time, by making your mortgage payments regularly.
You may also want to pay down your mortgage with any unexpected money you receive, such as a bonus or tax refund. The longer you pay – in your regular payments, or in extra chunks – the faster you’ll reach that 20% equity threshold. At that point, you can start the conversation with your mortgage lender about kicking PMI to the curb.
Automatic drop off
If you reached 20% and didn’t realize it, don’t worry! PMI will automatically drop off when you reach 22% equity (or 78% loan to value). This is great news if you aren’t actively watching your home value in relation to your payments and will come as a nice surprise when your PMI is no longer required in that monthly mortgage payment.
Market changes and home appraisals
In some situations, it may make sense to get a new home appraisal. For example, if the market changes dramatically (and your home value goes up), you can reach that 20% equity by the total value increase, rather than through the payments you’ve made.
Here’s how that might work. Let’s say you start with a $200,000 home, and 20% would be equal to $40,000. If everything stays the same, you would be eligible to remove PMI when you have paid the lender $40,000 (and your loan balance is $160,000). But, if your home value changed significantly, and your home was suddenly worth $250,000, you would be eligible to remove PMI when if your loan amount was $200,000 or less. Since we know it’s the same home you started with, the change in home value can immediately get rid of your need for PMI.
The same could be true if you completed major improvements. For example, restoring an outdated home or repairing one that needed work, would increase the value from its original appraisal (when it was not looking so great). In these cases, the bank needs to verify the new value with an independent home appraiser. It’s not something you want to start without first doing your research to evaluate comps in your area, because you’ll pay the appraisal fee up front, whether or not your new home value is approved.
Another good option when your home value changes is to refinance. When you refinance your loan, you can essentially start over. You’ll take out a new loan, with new terms, and pay off your existing (original) loan. Often times, homeowners can reduce their overall payment if interest rates have gone down since their original loan and at the same time potentially eliminate PMI.
Know your rights
With any of these options, it’s important to know your rights as a homeowner. Before you call your lender to request early cancellation, discuss refinancing or talk about getting a new appraisal, do your research. Banks have certain requirements when it comes to your loan, but it doesn’t mean they’ll be immediately interested in lowering the payment you make to them. Get prepared and know your rights before you start any conversations.
It’s normal to wonder how soon you can get rid of PMI. After all, you’re paying for that insurance and it’s hard to see the benefit. But keep in mind, although the insurance isn’t a direct benefit to you, getting into a home sooner is!
Don’t be afraid of a lower down payment
Don’t let PMI scare you away from that lower down payment. Take advantage of the options it gives you and remember that it’s not permanent. Approximately 13% of homeowners use PMI to get into their home and on average, they only pay it for five and a half years. During that time, you could be enjoying home-ownership and reaping the benefits.
Start gaining equity sooner
For example, instead of renting and making payments to someone else, you’ll be gaining equity in your home. Over time, properties typically appreciate in value and as a home-owner, that will directly benefit you. Think of your home as an investment that you can cash in one day – instead of making payments to a landlord that will cash in with your money!
Your own space
Of course, in addition to that, you’ll get to enjoy your own space that’s actually yours. We’ve all experienced moving into a new apartment, only to learn you’re not allowed to paint, change fixtures or even hardly decorate! Alternately, as an owner, you get to make your house a home. That means no one can stop you if you’ve had your heart set on a lime green living room your whole life!
We hope this helps you purchase sooner!
At Digs, we want you to learn the pros and cons of different down payment options because we know the more informed you are, the more you’ll be able to make the best decisions for your situation. There are pros and cons to each option we’ve presented here, even choosing the option of a higher down-payment.
What we want you to know is that each scenario and home-buyer is unique and you should choose what’s right for you. Don’t get scared when your parents tell you a 20% down-payment is the only option. Those days are over and you’re in the driver’s seat!
Check out all the ways we help future homeowners. We’ll keep the information coming so you can stay up to speed on your options and take advantage of what works best for you!