Before buying a home, you should ideally save enough money for a 20% down payment. If you can't, it's a safe bet that your lender will force you to secure private mortgage insurance (PMI) prior to signing off on the loan. The purpose of the insurance is to protect the mortgage company if you default on the note.
Private mortgage insurance sounds like a great way to buy a house without having to save for a down payment. Sometimes it is the only option for new homebuyers. However, there are several reasons would-be homeowners should try to avoid needing this insurance. In this article, we'll discuss six reasons not to pay PMI and explore a possible way to avoid it altogether.
Six Good Reasons to Avoid PMI
- Cost – Private mortgage insurance typically costs between 0.5% to 1% of the entire loan amount on an annual basis. This means on a $100,000 loan, the homeowner could be paying as much as $1,000 a year—or $83.33 per month—assuming a 1% PMI fee. However, the median U.S. home price, according to Zillow is about $205,000 (as of Nov. 30, 2017), which means families could be spending nearly $200 a month on the insurance. That's as much as a small car payment!
- May not be deductible – As of 2017, private mortgage insurance was tax deductible, but only if the married taxpayer's adjusted gross income (AGI) is less than $109,000 per year. This means many dual-income families will be left out in the cold. The ability to deduct PMI is the result of a tax provision that has been expiring and getting extended each year, so in the future, homeowners may not be able to deduct PMI regardless of their AGI.
- Your heirs get nothing – Most homeowners hear the word "insurance" and assume that their spouse or their kids will receive some sort of monetary compensation if they die. This is simply not true. The lending institution is the sole beneficiary of any such policy, and the proceeds are paid directly to the lender (not indirectly to the heirs first). If you want to protect your heirs and provide them with money for living expenses upon your death, you'll need to obtain a separate insurance policy. Don't be fooled into thinking PMI will help anyone but your mortgage lender.
- Giving money away – Homebuyers who put down less than 20% of the sale price will have to pay mortgage insurance until the total equity of the home reaches 20%. This could take years, and it amounts to a lot of money the homeowner is literally giving away. To put the cost into better perspective, if a couple who owns a $250,000 home were to instead take the $208 per month they were spending on PMI and invest it in a mutual fund that earned an 8% annual compounded rate of return, that money would grow to $37,707 (assuming no taxes were taken out) within 10 years.
- Hard to cancel – As mentioned above, usually when a homeowner's equity tops 20%, he or she no longer has to pay PMI. However, eliminating the monthly burden isn't as easy as just not sending in the payment. Many lenders require the homeowner to draft a letter requesting that the PMI be canceled, as well as receive a formal appraisal of the home prior to its cancelation. All in all, this could take several months depending upon the lender, during which PMI still has to be paid. (For related reading, see: How to Get Rid of Private Mortgage Insurance.)
- Payment goes on and on – One final issue that deserves mentioning is some lenders require the homeowner to maintain a PMI contract for a designated period of time. So, even if the homeowner has met the 20% threshold, he or she may still be obligated to keep paying for the mortgage insurance. Read the fine print of your PMI contract to determine if this is the case for you.
How to Avoid Paying Private Mortgage Insurance
In some circumstances PMI can be avoided by using a piggy-back mortgage. It works like this: Assume a prospective homeowner wants to purchase a house for $200,000, but he or she only has enough money saved for a 10% down payment (not enough to avoid PMI). By entering into what is known as an 80/10/10 agreement, the individual will take out a loan totaling 80% of the total value of the property, or $160,000. A second loan, referred to as a piggyback, will be taken out for $20,000 (or 10% of the value). Finally, as part of the transaction, the buyer puts down the final 10%, or $20,000.
By splitting up the loans, the homeowner may be able to deduct the interest on both loans, and avoid PMI altogether. Of course, there is a catch. Very often the terms of a piggyback loan are risky. Many are adjustable-rate loans, contain balloon provisions, or are due in 15 or 20 years (as opposed to more conventional loans, which are due in 30 years).
The Bottom Line
Private mortgage insurance is expensive. Unless you think you'll be able to attain 20% equity in the home within a couple of years, it probably makes sense to wait until you can make a larger down payment or consider a less expensive home, which will make a 20% down payment more affordable.
(For related reading, see: How to Outsmart Private Mortgage Insurance.)