The days of putting a 20 percent down payment on a home are over — plenty of programs now make it possible to buy a home with a low down payment.
However, if you decide to go this route to get into a home a bit faster, prepare yourself for higher costs. When you put down less than 20 percent, most lenders require you to pay for private mortgage insurance (PMI).
What is PMI?
Private mortgage insurance is a way to protect the lender if you aren’t able to make payments on your home loan.
If you can’t put down 20 percent for a down payment, lenders get nervous. After all, it’s their money you’re using to buy that home. If you don’t pay them back, they lose.
PMI basically provides insurance coverage to the lender and reduce their risk. In most cases, you pay the premiums, but the lender gets the payout if you default on your loan.
Your private mortgage insurance payments won’t stop a lender from foreclosing if you can’t make your payments. You still lose the home — and all your PMI payments.
There are two main types of PMI:
With borrower-paid PMI, you pay the cost of mortgage insurance premiums. You can choose to either pay monthly or pay a single upfront premium.
You can cancel a monthly PMI payment down the road, lowering your monthly payment later. This is because you agree to pay as you go, and only pay for the insurance coverage that you use.
Upfront, single premium private mortgage insurance allows you to pay a single premium at settlement. Additionally, even though it’s called an “upfront” premium, you can wrap the total cost into your mortgage and pay it monthly, according to the National Association of Realtors. But it’s still considered a fixed cost.
However, if you choose single premium, you have paid upfront. So you don’t get to cancel your PMI payments later because you’ve paid everything already. There’s nothing to cancel.
Even though private mortgage insurance is often something paid for by the borrower, the lender might actually be willing to pay for it.
However, if the lender agrees to pay the cost of PMI, you have to make concessions elsewhere. In many cases, according to The New York Times, that means a higher interest rate.
If mortgage rates are low enough, it can be worth it to accept a slightly higher interest rate to avoid paying PMI. As mortgage rates rise, though, lender-paid PMI might not be worth it. Since you already agreed to a higher interest rate, and the lender pays the PMI, there’s nothing to cancel later.
How much is PMI?
Your private mortgage insurance premiums are based on the amount of your loan. The National Association of Realtors says it’s common to pay between 0.3 percent and 1.15 percent of your loan on an annual basis.
If you buy a home for $250,000 and put down 10 percent, your loan will be for $225,000. If your annual PMI premium is 0.75 percent, you will pay $1,687.50 per year. Divide that by 12 to get an addition of $140.63 to your monthly mortgage payment.
With single-premium PMI, the National Association of Realtors says you might pay between 1 and 2 percent of the loan’s value at closing. Your total PMI cost on that $225,000 mortgage would be $3,375 if your premium is 1.5 percent. You can pay that upfront or add that amount to your mortgage for a total loan of $228,375.
Of course, if PMI is part of your mortgage, you’ll pay interest on it. But then it also becomes tax-deductible.
What about lender-paid PMI?
If the borrower paid for insurance monthly, the payment on a 30-year loan at 3.99 percent would be $1,558.50. If the borrower chose lender-paid insurance, the interest rate would rise to 4.25 percent but the monthly payment would still be $82 lower, at $1,476.
However, even though the monthly payment is lower, the long-term costs could be higher with lender-paid PMI. That’s because when you pay a monthly premium as the borrower, you can cancel the private mortgage insurance. Eventually, you stop making the premium payments.
Your higher interest rate won’t go away unless you refinance to a lower mortgage rate.
How to cancel PMI
If you have borrower-paid monthly PMI, you get to cancel when you pay down your mortgage far enough. Once your home’s loan-to-value (LTV) ratio falls to 80 percent, you can cancel your PMI, according to the Consumer Financial Protection Bureau (CFPB).
Here are the criteria you must meet if you want to cancel your borrower-paid monthly private mortgage insurance:
- Be current on your mortgage payments and have a good payment history.
- Certify that there aren’t junior liens (like a second mortgage) on your home.
- Get an appraisal to verify that your home’s value hasn’t fallen. If your home has decreased in value enough, you might not be at the proper LTV.
- Make your PMI cancellation request in writing.
If your insurance plan qualifies for cancellation, the CFPB says your mortgage contract should include the date you are projected to reach 80 percent LTV. You can speed things up, though, by making extra mortgage payments.
Automatic PMI termination
If you forget to ask for a cancellation, government regulations have your back. The CFPB points out that when your LTV is scheduled to reach 78 percent, the lender has to terminate the PMI payments as long as you are up-to-date on your payments.
Additionally, if you get to the midpoint of your loan and you still aren’t at 78 percent LTV, the lender must still cancel your private mortgage insurance. If you have a 30-year loan, you no longer have to worry about paying PMI once you hit the 15-year mark.
Once your PMI is canceled, you should see a reduction in your monthly payments.
What about FHA loans?
If you got your mortgage using a program through the FHA, things are different. You have mortgage insurance premiums on FHA loans if you don’t put down 20 percent.
However, cancellation isn’t so straightforward with this program. For FHA loans assigned after June 3, 2013, FHA insurance is only canceled if the mortgage is paid in full before the end of the original term.
Is PMI worth paying?
Whether or not PMI is worth paying depends on your priorities and how much house you can afford.
Freddie Mac offers a cost comparison:
As you can see, a 20 percent down payment offers monthly savings of $232.75. Once the PMI drops off, the monthly payment with a smaller down payment becomes $962.70. You still save $152 each month by making a bigger down payment.
But if home prices rise before you save enough for that 20 percent, you might be better off buying now, anyways.
If home prices rise to $250,000, you’ll need $50,000 to make a 20 percent down payment. That may be more than you were originally planning for. If mortgage rates rise significantly, your monthly payments (and overall cost of the loan) would increase, too.
In those instances, you don’t save at all by waiting.
In the end, you need to decide whether it makes sense to buy a home now and pay the cost of PMI, or if it’s smarter to wait and save up the 20 percent down payment you need to avoid PMI.