If you’re thinking about buying a house but don’t have enough money saved up for a 20% down payment, you will need to know a thing or two about private mortgage insurance. PMI as it is more commonly called, enables you to buy a home with a down payment as low as 3% with a conventional mortgage — helping a lot more people buy homes much sooner than they could if they had to save up for a larger down payment.
The good news is, it’s often only a temporary part of your monthly mortgage payment. You have options to get rid of PMI, or reduce how much of it you pay monthly, or with time, patience and ontime monthly payments it will drop off on it’s own.
We’ll discuss what PMI is and why you need it below.
What exactly is private mortgage insurance?
Private mortgage insurance, also called PMI, is a type of insurance that protects a lender in the event that you aren’t able to make payments on your loan and end up defaulting.
But homebuyers benefit, too. PMI allows homebuyers to get conventional mortgage financing for homes with as little a 3% down, typically at a lower cost than other programs designed to help people with little cash for a down payment, like FHA loans.
Your monthly payment usually includes principal, interest, taxes and insurance, also known as PITI. You’ll need to add PMI to your monthly payment if you want to be able to buy a home with less than a 20% down payment. The higher your down payment, the lower your monthly mortgage insurance. Lenders charge you more for a lower down payment because the risk of default is higher.
How much does PMI cost?
The amount you pay each month is generally determined by your credit score and your down payment. The better your credit score, the lower your payment.
But credit scores are not the only component of your private mortgage insurance payment. A number of other factors will increase or decrease how much you pay.
- Down payment: Every 5% you put down affects the rate you pay. As a general rule of thumb, the more you put down, the lower the PMI rate will be.
- State you live in: Different states have different risk grades, resulting in higher or lower PMI premiums.
- Debt-to-income ratio: Your debt-to-income (DTI) ratio is a measure of how much debt you have compared to your pre-tax income. While conventional programs offered by Fannie Mae and Freddie Mac may allow for a DTI ratio as high a 50%, many PMI companies will require a higher credit score of at least 720.
- Type of property: Condominiums and manufactured homes may require more expensive PMI.
- Type of occupancy: Primary residences will always get the best rates, while second homes are slightly more expensive.
- Number of borrowers: PMI insurers consider two borrowers safer than one, so couple borrowers get slightly better rates than single borrowers.
- Fixed rate vs. ARM: A fixed rate features a payment that never changes during the life of the loan, versus an adjustable rate mortgage (ARM) that will adjust after the initial fixed rate period ends. Because of the risk the payment could become unaffordable when the ARM eventually adjusts, PMI companies charge slightly higher rates.
- Number of units: Properties with more than one unit are considered higher risk to a lender, so PMI companies also mark up the mortgage insurance if you purchase a property with two to four units.
- Detached or attached property: A property that is attached has slightly higher rates, since there is always the risk of your attached neighbor doing something that could damage your home.
- Special programs: First-time homebuyer programs actually offer cheaper mortgage insurance rates than other conventional loan programs. However, the premiums are still impacted by credit scores, so even if the rate is lower for the first time homebuyer program, your payment may still be high because of a low credit score.
Private mortgage insurance vs. FHA loan mortgage insurance
PMI usually ends up being cheaper than the mortgage insurance premiums you pay for an FHA loan. That loan program includes two types: one paid monthly, and one larger upfront payment that is usually financed into the loan.
Below is a table that shows the costs of private mortgage insurance for a $200,000 conventional loan with 3% down, versus an FHA loan with 3.5% down, and how the cost changes the lower your credit score is.
|PMI Costs on Conventional Loan vs. FHA Loan|
|FICO Score||Monthly PMI||FHA Monthly MIP||FHA upfront MIP|
As you can see above, once your score drops below 700, the insurance premium for the FHA loan is cheaper than the monthly amount for PMI. The $3,500 is financed top of the loan amount, and is included in the calculations of the monthly payment listed above.
Where did mortgage insurance come from?
Imagine if you had to make a 50% down payment on a house, and had to pay the entire balance off in five years. If you were house hunting in the early 1900s, those were normal terms, and they kept many people renting for most of their lives.
In 1934, the Federal Housing Administration was created to allow for lower down payments by providing insurance to the lenders that made them. The new FHA loan program also eventually extended the time to pay a mortgage off to 30 years.
The private mortgage market eventually adopted both of those innovations. In 1957, the first private mortgage insurance company opened, giving borrowers a cheaper alternative to the expensive government mortgage insurance premium. If weren’t for private mortgage insurance, or mortgage insurance at all for that matter, many people would spend most of their lives saving for a down payment, or just scrap homeownership altogether and stay renters.
Options to pay private mortgage insurance
One of the benefits of PMI besides the potential for lower monthly payments, is the variety of payment options. If you have a seller that is contributing toward your closing costs, you may be able to use the concession toward getting a lower premium for your PMI.
Below are some more creative options besides the traditional monthly options discussed so far.
This allows you to pay the entire premium in one lump sum, rather than paying it monthly. If your purchase contract calls for the seller to pay some of your closing costs, this can be a great way to end up with a monthly payment with no mortgage insurance.
Lender-paid mortgage insurance
This may be a good option if you have a very high credit score, as it absorbs the costs of the mortgage insurance with an increase to your rate. The higher your credit score, the less the markup is to your interest rate, but the obvious drawback is you end up with a higher rate for the life of your loan.
Split premium mortgage insurance
This is a combination of monthly paid and lump sum, and allows you to pick and choose the best combination based on how much money you can contribute toward the lump sum. While you may not get the benefit of a full mortgage insurance buyout like you would have with the borrower single premium financed, you could end up with a lower premium that you would have with normal borrower paid monthly premiums.
How to cancel private mortgage insurance
The beauty of private mortgage insurance is that you only need it while you have less than 20% equity. There are three ways you can get rid of or lower your PMI.
Wait until your payments get you to 22% equity
PMI automatically drops off of your payment once you’ve paid your principal down to 78% of the original sales price or appraised value. There’s nothing you have to do because lenders are required by law to remove once you reach that payment milestone.
Request an appraisal to prove you have 20% equity
House prices have risen the past five years, so there is always the chance that your value may have risen enough to justify the lender canceling your PMI. You’ll likely need to foot the bill for the appraisal, but if it comes in showing you have enough equity to remove your PMI, it will be worth the expense.
Refinance and pay down your principal
You can always pay down the principal with a full refinance to 80% of the value of your home, and you will no longer have to pay mortgage insurance. If you’re right on the brink of having 20% equity, it may be worth the extra money to do a full refinance so you can permanently remove mortgage insurance from your monthly payment.
Ways to avoid PMI
PMI is something that you want to avoid for a number of reasons, if you can. The cost can range from .15% to 1.95% of your loan amount every year depending on the factors outlined above.
One other drawback to PMI is that the Tax Cuts and Job Act (TCJA) removed the deductibility of private mortgage insurance premiums, which means you can’t write it off like your mortgage interest. This removes the tax benefit to homeowners, making it a sunk cost that only benefits the investor who holds your mortgage in the event that you default.
If 20% is just in the cards for you to save up in your checking and savings, there are other options to consider to avoid PMI.
Get a gift from a family member
If you’re short the 20% down payment from your own resources, you can get a gift from a family member for the full amount of the down payment, or just a portion of it. Your family member will have to provide documentation of the funds they are gifting you, and provide a gift letter confirming all the funds are a gift.
Take out a 401(k) loan
Depending on how long you’ve been at your job and how much you have vested, you may be able to take out a loan against your 401(k) for all or a portion of your down payment. Lenders don’t consider a 401k loan as a monthly debt, so even it won’t hurt your debt-to-income ratio like other types of loans would.
Sell an asset
Maybe you’re into classic cars and have one you could sell, or you’ve finally decided to trade in the RV for a house without wheels. You can sell an asset and use the proceeds to make your down payment.
You’ll have to prove your ownership, and keep all the paperwork related to the sale, including the bill of sale, copy of the title showing ownership transferring to the buyer, and deposits of the funds into your accounts. You’ll also need to verify the value of the asset with some third party valuation source, like a Kelley Blue book for cars.
Can a PMI company decline my loan?
Although it is very rare, there are cases where a PMI company could decline your loan. Fortunately, just like mortgage lenders, there are many private mortgage insurance companies to choose from, and some may have more liberal underwriting guidelines than others.
The one factor that has become an issue in recent years for borrowers is the increase in the minimum score requirement for DTIs over 45%. Many PMI companies now require at least a 700 score if the DTI exceeds 45%, so you could end up with a declined loan for your PMI, even if your lender has approved your loan.
In many cases, a different PMI company may be willing to do the loan, but chances are the premiums will be higher to compensate for the extra risk the PMI company is taking on by approving a higher DTI.
If all else fails, you can always switch to an FHA loan, which allows for higher DTIs with lower credit scores, and no markup for score at all.
The bottom line
Private mortgage insurance may seem like just another expense in a long line of costs associated with buying or refinancing a home. For anyone trying to purchase a home with less than 20% who has good credit scores, PMI is a very cost-effective way to keep your monthly payment as low as possible.