Putting an initial down payment on a home is an unavoidable part of the home-buying process. Depending on the type of loan the buyer secures, the down payment required at closing can be anywhere from 3% to 20% of the property’s price. If the borrower puts down less than 20% of the home purchase price, they must pay mortgage insurance on the loan.
Private mortgage insurance provides a safety net for the lender should the borrower default on the loan. Read this article to learn more.
What Is Private Mortgage Insurance (PMI) And How Does It Work?
Private mortgage insurance is an insurance premium that lenders require when buyers who qualify for a conventional loan put less than 20% of a home’s purchase price down for the purchase of the property.
While a larger down payment means smaller monthly payments over time, it can be difficult for a buyer to put a large sum down upfront. For example, lenders may offer an applicant a 3% down payment for the loan. Because the lenders have to loan more money for the home purchase, the lender is at a higher risk of the buyer defaulting on the loan before they’ve paid the necessary 20% of the total loan amount.
There are two options for paying PMI:
Single Premium PMI
Single Premium PMI occurs when the borrower fully pays the PMI in a single payment at signing. Alternatively, the lender can break the amount into monthly payments rolled into the mortgage.
Monthly PMI appears in the loan’s monthly payment as an additional cost. Therefore, the overall mortgage payment increases.
Is Private Mortgage Insurance Required?
Private mortgage insurance is only required if the borrower puts less than 20% down on a conventional home loan at the time of purchase. Once the borrower reaches the threshold of 20% down of their current home value, they can request the PMI be removed.
How Much Does Private Mortgage Insurance Cost?
PMI costs anywhere from $30 to $75 per month for every $100,000 borrowed. The actual rate for PMI coverage depends on the borrower’s credit score and the loan-to-value ratio when they sign their documents. Here are some factors that might influence how much private mortgage insurance may cost:
Down Payment Amount
If a borrower puts down at least 20% of the overall home value, PMI may not be necessary. However, if a borrower pays 3% of the home value at closing and borrows the other 97% from a lender, the borrower would have to pay PMI until their borrowed money from the lender drops to 80% of their home value. Once they reach the 80% threshold, the borrower can request the lender remove the PMI coverage.
Loan-to-Value (LTV) Ratio
The loan-to-value ratio is the amount a homeowner borrows on their mortgage compared to the value of their home. If a borrower pays 5% of their home value at closing and takes the other 95% out as a loan, the loan-to-value ratio at that time is 95%.
The stronger a borrower’s credit score, the lower their PMI payment will be. Borrowers with higher credit scores are seen as less risky to the lender.
This type of PMI coverage only applies to a conventional loan. An FHA loan has a similar program called Mortgage Insurance Premium (MIP). MIP requires borrowers to make an extra payment at closing plus a payment each month with the mortgage.
If an FHA borrower puts down less than 10% of their home value at closing, MIP needs to be paid by the borrower for the life of the loan. If the borrower puts down more than 10% of the home value but less than 20%, the lender will add MIP to the loan. However, the borrower can cancel it after 11 years.
How to Avoid Private Mortgage Insurance
A borrower who wishes to avoid PMI should consider making a down payment of at least 20% of the home’s value. If the borrower only has 3% to put down for the purchase of their home, the lender can opt-out of the PMI coverage, but that would cause the homeowner’s interest rate to increase for the duration of the loan.
The borrower could also qualify for a piggyback mortgage. A piggyback mortgage requires a qualified borrower to simultaneously take out a home equity loan or home equity line of credit on their home as the first mortgage. These are considered second mortgages.
A typical piggyback mortgage follows an 80/10/10 structure. The shopper borrows 80% of the home value with the first mortgage, the second loan would cover 10% of the home value, and the borrower’s down payment covers the remaining 10% of the mortgage.
How to Remove Private Mortgage Insurance if Currently Paying
The federal Homeowners Protection Act allows borrowers to cancel PMI if they have either paid 20% of the home’s equity or increased its value to 80% LTV.
To request the cancellation, the homeowner needs to:
- Make a formal request in writing
- Make sure the property hasn’t decreased in value
- The homeowner doesn’t hold a second mortgage on the home
The borrower should also ensure they’re current on their mortgage payments and have a positive payment history.
20% Home Equity
Once the borrower’s principal payments meet the threshold for 20% paid off the home’s current value, the borrower can submit a request in writing to remove the PMI coverage.
If a homeowner makes improvements to the home that increase the overall value, like adding a bathroom, the homeowner can submit a request for the PMI cancellation.
Home Value Increase
As a general rule, home values appreciate over time. If enough time passes or there’s a sharp upturn in the market, the home’s value can increase enough for the principal paid by the homeowner to reach the 80% required LTV for PMI cancellation. Just note that a lender might hire an appraiser to establish the home’s value before they cancel the PMI coverage, which the homeowner would be required to pay.