One of the many obstacles to buying your dream home is coming up with a down payment. First-time home buyers, especially, may find that they can’t put down the full 20 percent on a conventional loan. Because of this, home buyers should understand their options for private mortgage insurance (PMI) since it is a common expense added to a mortgage if the full 20 percent down payment can’t be made.
While there can be lenders that offer loan programs with no down payment and no PMI, it’s best to always plan for this expense if you can’t make a full down payment. Let’s look at what exactly private mortgage insurance is, so you’re prepared in the case that PMI is required.
What Is Private Mortgage Insurance?
Private mortgage insurance protects lenders against loss if a borrower fails to repay a home loan. PMI does not protect you as the borrower; instead, this type of insurance protects the lender if you default on your loan.
When a home buyer makes a low down payment, the loan-to-value (LTV) ratio of the mortgage can be up to 80 percent or more. With a higher LTV ratio, there’s a higher risk profile for the lender since, at that point, they own a larger stake in the home than you do. Unlike most insurance policies, this type of insurance protects the lender’s investment in your new home, allowing them to recoup more money if you default in the early years of ownership.
You’re more likely to pay PMI with a conventional home loan. Other loan programs may require PMI or have other types of insurance policies you must pay to protect the lender. When working with your lender, be sure to understand what types of insurance policies you may be required to pay for if your down payment will be less than 20 percent.
How Does Private Mortgage Insurance Work?
PMI works by protecting the lender if the borrower defaults on their loan. For example, if the borrower loses their primary source of income and cannot make payments for several months, or the borrower stops making payments at any point during the loan term, the lender will be reimbursed by the private mortgage insurance company for a portion of the loan amount.
You may be wondering why the borrower has to pay for private mortgage insurance if its purpose is to protect the lender. Essentially, the lender is taking on a higher risk than the borrower when the loan is first acquired since the down payment is not being made in full, so the borrower must be able to compensate the lender in the event that they default.
4 Types of Private Mortgage Insurance
There are several types of private mortgage insurance:
- Borrower-Paid PMI: This is the most common type of PMI and is typically an additional fee that’s added to your mortgage payment each month.
- Single-Premium PMI: This type of PMI is paid in a lump sum upfront, meaning you pay the full amount of the insurance at the time of closing. While this does give you the advantage of lower monthly mortgage payments, some people may not have the money to pay the full amount for the insurance upfront. Additionally, if you move after only a few years, the money you already paid for the insurance typically can’t be refunded.
- Lender-Paid PMI: In this situation, your lender will technically cover the cost of the mortgage insurance payment. However, to make up the difference, you usually will have a higher interest rate over the lifetime of your home loan.
- Split-Premium PMI: This is the least common type of PMI. In this situation, you pay for part of the insurance at the time of closing as a lump sum, while the other half is paid monthly with your mortgage payment. This type of PMI offers a great balance for some borrowers since you don’t have to pay as much upfront, and your monthly mortgage payment won’t be as high as it would with borrower-paid PMI.
How Much Does PMI Cost?
The cost of private mortgage insurance will differ since many variables can contribute to the PMI amount. These may include:
- Which private mortgage insurance plan you have
- Whether you have a fixed or adjustable interest rate for your loan
- The loan term
- Your credit score
- Your loan-to-value ratio and down payment amount
- The amount of PMI coverage required by your lender
- Whether the PMI premium is refundable or not
- Other risk factors, such as if the loan is for a cash-out refinance, investment property, or second home
Ultimately, the greater the risk factors when you take out the loan, the more PMI you will pay. While these factors can determine how much PMI will cost for your mortgage, you can expect the cost to range anywhere from 0.5% to 1% of the original loan amount every year.
When Can You Stop Paying for PMI?
Fortunately, PMI is not an expense you’ll have to pay for the entire loan term. Once you’ve reached at least 20 percent equity of the loan—either from rising home values or from paying down the balance over time—your lender can remove PMI from your monthly mortgage payments.
If you have PMI and want to cancel it, you’ll need to reach out to your lender. They may require you to refinance your loan in order to cancel PMI. However, PMI is typically canceled anyway when the loan reaches 78 percent of the home’s original value.
If you are in the market for a home and are concerned about being able to afford PMI, it is important to do your research and work with a knowledgeable lender who can help you understand your options and find the best solution for your needs.
If you have questions about PMI or whether it’s right for you, First Fidelis is here to help. Our lenders can help you understand the pros and cons of PMI and how it will affect your monthly mortgage payments. Contact us today at 913-205-9978.