Private mortgage insurance (PMI) is an insurance policy that protects lenders from the risk of default and foreclosure. Generally, if you need financing to buy a home and make a down payment of less than 20% of its cost, your lender will probably require you to buy insurance from a PMI company prior to signing off on the loan. Although it costs extra, PMI allows buyers who cannot make a significant down payment (or those who choose not to) to obtain financing at affordable rates.
6 Reasons To Avoid Private Mortgage Insurance
How Not to Pay PMI
One way to avoid paying PMI is to make a down payment that is equal to at least one-fifth of the purchase price of the home; in mortgage-speak, the mortgage's loan-to-value (LTV) ratio is 80%. If your new home costs $180,000, for example, you would need to put down at least $36,000 to avoid paying PMI. While that's the simplest way to avoid PMI, a down payment that size may not be feasible.
In addition, if the value of your home has appreciated to an amount that drops your LTV below 80%, some banks will allow you to submit a request to cancel PMI. However, in this scenario it is likely that the bank would require a professional appraisal to accompany the request, the cost of which is assumed by the borrower.
Another option for qualified borrowers is a piggyback mortgage. In this situation, a second mortgage or home equity loan is taken out at the same time as the first mortgage. With an "80-10-10" piggyback mortgage, for example, 80% of the purchase price is covered by the first mortgage, 10% is covered by the second loan, and the final 10% is covered by your down payment. This lowers the loan-to-value (LTV) of the first mortgage to under 80%, eliminating the need for PMI. For example, if your new home costs $180,000, your first mortgage would be $144,000, the second mortgage would be $18,000, and your down payment would be $18,000.
A final option is lender-paid mortgage insurance (LMPI) where the cost of the PMI is included in the mortgage interest rate for the life of the loan. Therefore, you may end up paying more in interest over the life of the loan.
- Private mortgage insurance (PMI) is incurred if you need to finance more than 80% of the purchase price of a home.
- You can avoid PMI by simultaneously taking out a first and second mortgage on the home so that no one loan constitutes more than 80% of its cost.
- You can opt for lender-paid mortgage insurance (LMPI), though this often increases the interest rate on your mortgage.
- You can request the cancellation of PMI payments once you have built up at least a 20% equity stake in the home.
Ending PMI Early
Once you've had your mortgage for a few years, you may be able to get rid of PMI by refinancing—that is, replacing your current loan with a new one—though you’ll have to weigh the cost of refinancing against the costs of continuing to pay mortgage insurance premiums. You may also be able to ditch it early by prepaying your mortgage principal so that you have at least 20% equity (ownership) in your home. Once you have that amount of equity built up, you can request the lender cancel your PMI.
Assuming you stay current with your mortgage payments, PMI does eventually end in most cases. Once the mortgage's LTV ratio drops to 78%—meaning your down payment, plus the loan principal you’ve paid off, equals 22% of the home’s purchase price—the federal Homeowners Protection Act requires the lender to automatically cancel the insurance.
Scott Gaynor, CFP®, AIF®
KCS Wealth Advisory, LLC, Los Angeles, CA
Several ways exist to avoid PMI:
- Put 20% down on your home purchase
- Lender-paid mortgage insurance (LPMI)
- VA loan (for eligible military veterans)
- Some credit unions can waive PMI for qualified applicants
- Piggyback mortgages
- Physician loans
There are a few things to note about the above options.
With LPMI, the lender pays the PMI cost, but will most likely provide you with a higher mortgage rate. Also, LPMI does not get eliminated like PMI eventually does.
With a piggyback mortgage, buyers can use two loans instead of one (piggyback) to purchase a home. The first is a traditional mortgage loan. The second includes either a home equity line of credit or a standard home equity loan. The second loan covers the remaining amount to obtain the 20% down payment and usually has a higher rate.