If you're making a down payment of less than 20% on a home, it's essential to understand your options for private mortgage insurance (PMI). Some people simply cannot afford a down payment in the amount of 20%. Others may elect to put down a smaller down payment in favor of having more cash on hand for repairs, remodeling, furnishings, and emergencies.
Private Mortgage Insurance (PMI)
What Is Private Mortgage Insurance (PMI)?
Private mortgage insurance (PMI) is a type of insurance that a borrower might be required to buy as a condition of a conventional mortgage loan. Most lenders require PMI when a homebuyer makes a down payment of less than 20% of the home's purchase price.
When a borrower makes a down payment of less than 20% of the property's value, the mortgage's loan-to-value (LTV) ratio is over 80% (the higher the LTV ratio, the higher the risk profile of the mortgage for the lender).
Unlike most types of insurance, the policy protects the lender's investment in the home, not the individual purchasing the insurance (the borrower). However, PMI makes it possible for some people to become homeowners sooner. For individuals who elect to put down between 5% to 19.99% of the residence's cost, PMI allows them the possibility of obtaining financing.
However, it comes with additional monthly costs. Borrowers must pay their PMI until they have accumulated enough equity in the home that the lender no longer considers them high-risk.
PMI costs can range from 0.25% to 2% of your loan balance per year, depending on the size of the down payment and mortgage, the loan term, and the borrower's credit score. The greater your risk factors, the higher the rate you'll pay. And because PMI is a percentage of the mortgage amount, the more you borrow, the more PMI you’ll pay. There are several major PMI companies in the United States. They charge similar rates, which are adjusted annually.
While PMI is an added expense, so is continuing to spend money on rent and possibly missing out on market appreciation as you wait to save up a larger down payment. However, there's no guarantee you'll come out ahead buying a home later rather than sooner, so the value of paying PMI is worth considering. Some potential homeowners may need to consider Federal Housing Administration (FHA) mortgage insurance. However, that only applies if you qualify for a Federal Housing Administration loan (FHA loan).
- You will need private mortgage insurance (PMI) if you're purchasing a home with a down payment of less than 20% of the home's cost.
- Be aware that PMI is intended to protect the lender, not the borrower, against potential losses.
- There are four main types of mortgage insurance you can purchase: Borrower-Paid Mortgage Insurance, Single-Premium Mortgage Insurance, Lender-Paid Mortgage Insurance, and Split-Premium Mortgage Insurance.
- If you obtain a Federal Housing Authority loan for your home purchase, there is an additional type of insurance you will need.
Private Mortgage Insurance (PMI) Coverage
First, you should understand how PMI works. For example, suppose you put down 10% and get a loan for the remaining 90% of the property’s value—$20,000 down and a $180,000 loan. With mortgage insurance, the lender's losses are limited if the lender has to foreclose on your mortgage. That could happen if you lose your job and can't make your payments for several months.
The mortgage insurance company covers a certain percentage of the lender’s loss. For our example, let’s say that percentage is 25%. So if you still owed 85% ($170,000) of your home’s $200,000 purchase price at the time you were foreclosed on, instead of losing the full $170,000, the lender would only lose 75% of $170,000, or $127,500 on the home’s principal. PMI would cover the other 25%, or $42,500. It would also cover 25% of the delinquent interest you had accrued and 25% of the lender’s foreclosure costs.
If PMI protects the lender, you may be wondering why the borrower has to pay for it. Essentially, the borrower is compensating the lender for taking on the higher risk of lending to you—versus lending to someone willing to put down a larger down payment.
How Long Do You Have to Buy Private Mortgage Insurance (PMI)?
Borrowers can request that monthly mortgage insurance payments be eliminated once the loan-to-value ratio drops below 80%. Once the mortgage's LTV ratio falls to 78%, the lender must automatically cancel PMI as long as you're current on your mortgage. That happens when your down payment, plus the loan principal you've paid off, equals 22% of the home's purchase price. This cancellation is a requirement of the federal Homeowners Protection Act, even if your home’s market value has gone down.
Types of Private Mortgage Insurance (PMI)
1. Borrower-Paid Mortgage Insurance
The most common type of PMI is borrower-paid mortgage insurance (BPMI).
BPMI comes in the form of an additional monthly fee that you pay with your mortgage payment. After your loan closes, you pay BPMI every month until you have 22% equity in your home (based on the original purchase price). At that point, the lender must automatically cancel BPMI, as long as you’re current on your mortgage payments. Accumulating enough home equity through regular monthly mortgage payments to get BPMI canceled generally takes about 11 years.
You can also be proactive and ask the lender to cancel BPMI when you have 20% equity in your home. In order for your lender to cancel BPMI, your mortgage payments must be current. You must also have a satisfactory payment history, and there must not be any additional liens on your property. In some cases, you may need a current appraisal to substantiate your home’s value.
Some loan servicers may permit borrowers to cancel PMI sooner based on home value appreciation. Suppose the borrower accumulates 25% equity due to appreciation in years two through five, or 20% equity after year five. In that case, the investor who purchased the loan may allow PMI cancellation after the home's increased value is proven. That can be done with an appraisal, a broker's price opinion (BPO), or an automated valuation model (AVM).
You also may be able to get rid of PMI early by refinancing. However, 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 cancel your PMI early by prepaying your mortgage principal so that you have at least 20% equity.
It is worth considering if you're willing to pay PMI for up to 11 years to buy now. What will PMI cost you in the long run? What will waiting to purchase potentially cost you? While it's true that you might miss out on accumulating home equity while you're renting, you'll also be avoiding the many costs of homeownership. These costs include homeowner's insurance, property taxes, maintenance, and repairs.
The other three types of PMI aren't nearly as common as borrower-paid mortgage insurance. You might still want to know how they work, in case one of them sounds more appealing, or your lender presents you with more than one mortgage insurance option.
2. Single-Premium Mortgage Insurance
With single-premium mortgage insurance (SPMI), also called single-payment mortgage insurance, you pay mortgage insurance upfront in a lump sum. That can be done either in full at closing or financed into the mortgage (in the latter case, it may be called single-financed mortgage insurance).
The benefit of SPMI is that your monthly payment will be lower compared to BPMI. That can help you qualify to borrow more to buy your home. Another advantage is that you don't have to worry about refinancing to get out of PMI. You also do not have to watch your loan-to-value ratio to see when you can get your PMI canceled.
The risk is that if you refinance or sell within a few years, no portion of the single premium is refundable. Further, if you finance the single premium, you’ll pay interest on it for as long as you carry the mortgage. Also, if you don’t have enough money for a 20% down payment, you may not have the cash to pay a single premium upfront.
However, the seller or, in the case of a new home, the builder can pay the borrower’s single-premium mortgage insurance. You can always try negotiating that as part of your purchase offer.
If you plan to stay in the home for three or more years, single-premium mortgage insurance may save you money. Ask your loan officer to see if this is indeed the case. Be aware that not all lenders offer single-premium mortgage insurance.
3. Lender-Paid Mortgage Insurance
With lender-paid mortgage insurance (LPMI), your lender will technically pay the mortgage insurance premium. In fact, you will actually pay for it over the life of the loan in the form of a slightly higher interest rate. Unlike BPMI, you can't cancel LPMI when your equity reaches 78% because it is built into the loan. Refinancing will be the only way to lower your monthly payment. Your interest rate will not decrease once you have 20% or 22% equity. Lender-paid PMI is not refundable.
The benefit of lender-paid PMI, despite the higher interest rate, is that your monthly payment could still be lower than making monthly PMI payments. That way, you could qualify to borrow more.
4. Split-Premium Mortgage Insurance
Split-premium mortgage insurance is the least common type. It’s a hybrid of the first two types we discussed: BPMI and SPMI.
Here’s how it works: You pay part of the mortgage insurance as a lump sum at closing and part monthly. You don’t have to come up with as much extra cash upfront as you would with SPMI, nor do you increase your monthly payment by as much as you would with BPMI. One reason to choose split-premium mortgage insurance is if you have a high debt-to-income ratio. When that's the case, increasing your monthly payment too much with BPMI would mean not qualifying to borrow enough to purchase the home you want.
The upfront premium might range from 0.50% to 1.25% of the loan amount. The monthly premium will be based on the net loan-to-value ratio before any financed premium is factored in.
As with SPMI, you can ask the builder or seller to pay the initial premium, or you can roll it into your mortgage. Split premiums may be partly refundable once mortgage insurance is canceled or terminated.
5. Federal Home Loan Mortgage Protection (MIP)
There is an additional type of mortgage insurance. However, it is only used with loans underwritten by the Federal Housing Administration. These loans are better known as FHA loans or FHA mortgages. PMI through the FHA is known as MIP. It is a requirement for all FHA loans and with down payments of 10% or less. Furthermore, it cannot be removed without refinancing the home. MIP requires an upfront payment and monthly premiums (usually added to the monthly mortgage note). The buyer is still required to wait 11 years before they can remove the MIP from the loan if they had a down payment of more than 10%.
Cost of Private Mortgage Insurance (PMI)
The cost of your PMI premiums will depend on several factors.
- Which premium plan you choose
- Whether your interest rate is fixed or adjustable
- Your loan term (usually 15 or 30 years)
- Your down payment or loan-to-value ratio (LTV) (a 5% down payment gives you a 95% LTV; 10% down makes your LTV 90%)
- The amount of mortgage insurance coverage required by the lender or investor (it can range from 6% to 35%)
- Whether the premium is refundable or not
- Your credit score
- Any additional risk factors, such as the loan being for a jumbo mortgage, investment property, cash-out refinance, or second home
In general, the riskier you look according to any of these factors (usually taken into account whenever you are taking out a loan), the higher your premiums will be. For example, the lower your credit score and the lower your down payment, the higher your premiums will be.
According to data from Ginnie Mae and the Urban Institute, the average annual PMI typically ranges from .55% to 2.25% of the original loan amount each year. Here are some scenarios: If you put down 15% on a 15-year fixed-rate mortgage and have a credit score of 760 or higher, for example, you'd pay 0.17%, because you'd likely be considered a low-risk borrower. If you put down 3% on a 30-year adjustable-rate mortgage for which the introductory rate is fixed for only three years and you have a credit score of 630, your rate will be 2.81%. That happens because you'd be considered a high-risk borrower at most financial institutions.
Once you know which percentage applies to your situation, multiply it by the amount you’re borrowing. Then divide that amount by 12 to see what you’ll pay each month. For example, a loan of $200,000 with an annual premium of 0.65% would cost $1,300 per year ($200,000 x .0065), or about $108 per month ($1,300/12).
Estimating Rates for Private Mortgage Insurance (PMI)
Many companies offer mortgage insurance. Their rates may differ slightly, and your lender, not you, will select the insurer. Nevertheless, you can get an idea of what rate you will pay by studying the mortgage insurance rate card. MGIC, Radian, Essent, National MI, United Guaranty, and Genworth are major private mortgage insurance providers.
Mortgage insurance rate cards can be confusing at first glance. Here’s how to use them.
- Find the column that corresponds to your credit score.
- Find the row that corresponds to your LTV ratio.
- Identify the applicable coverage line. Search the web for Fannie Mae's Mortgage Insurance Coverage Requirements to identify how much coverage is required for your loan. Alternatively, you can ask your lender (and impress the pants off them with your knowledge of how PMI works).
- Identify the PMI rate that corresponds with the intersection of your credit score, down payment, and coverage.
- If applicable, add or subtract to that rate the amount from the adjustment chart (below the main rate chart) that corresponds with your credit score. For example, if you’re doing a cash-out refinance and your credit score is 720, you might add 0.20 to your rate.
- As we showed in the previous section, multiply the total rate by the amount you’re borrowing; this is your annual mortgage insurance premium. Divide it by 12 to get your monthly mortgage insurance premium.
Your rate will be the same every month, though some insurers will lower it after ten years. However, that's just before the point when you should be able to drop coverage, so any savings won't be that significant.
Federal Housing Administration (FHA) Mortgage Insurance
Mortgage insurance works differently with FHA loans. For the majority of borrowers, it will end up being more expensive than PMI.
PMI doesn't require you to pay an upfront premium unless you choose single-premium or split-premium mortgage insurance. In the case of single-premium mortgage insurance, you will pay no monthly mortgage insurance premiums. In the case of split-premium mortgage insurance, you pay lower monthly mortgage insurance premiums because you've paid an upfront premium. However, everyone must pay an upfront premium with FHA mortgage insurance. What is more, that payment does nothing to reduce your monthly premiums.
As of August 2020, the upfront mortgage insurance premium (UFMIP) is 1.75% of the loan amount. You can pay this amount at closing or finance it as part of your mortgage. The UFMIP will cost you $1,750 for every $100,000 you borrow. If you finance it, you’ll pay interest on it too, making it more expensive over time. The seller is permitted to pay your UFMIP as long as the seller’s total contribution toward your closing costs doesn’t exceed 6% of the purchase price.
With an FHA mortgage, you'll also pay a monthly mortgage insurance premium (MIP) of 0.45% to 1.05% of the loan amount based on your down payment and loan term. As the FHA table below shows, if you have a 30-year loan for $200,000 and you're paying the FHA's minimum down payment of 3.5%, your MIP will be 0.85% for the life of the loan. Not being able to cancel your MIPs can be costly.
Source: U.S. Department of Housing and Urban Development.
For FHA loans with a down payment of 10% or more, you can cancel your monthly MIPs after 11 years. But if you have 10% to put down, why get an FHA loan at all? You'd only want to do this if your credit score is too low to qualify for a conventional loan. Another good reason: if your low credit score would give you a much higher interest rate or PMI expense with a traditional loan than with an FHA loan.
You can get an FHA loan with a credit score as low as 580 and possibly even lower (though lenders might require your score to be 620 or higher). And you might qualify for the same rate you would on a conventional loan despite having a lower credit score: 660 versus 740, for example.
Without putting down 10% or more on an FHA mortgage, the only way to stop paying FHA MIPs is to refinance into a conventional loan. This step will make the most sense after your credit score or LTV increases considerably. Refinancing means paying closing costs, however, and interest rates might be higher when you're ready to refinance. Higher interest rates plus closing costs could negate any savings from canceling FHA mortgage insurance. Furthermore, you can't refinance if you're unemployed or have too much debt relative to your income.
In addition, FHA loans are more generous in allowing sellers to contribute to the buyer’s closing costs: up to 6% of the loan amount versus 3% for conventional loans. If you can't afford to buy a home without substantial closing cost assistance, an FHA loan might be your only option.
The Bottom Line
Mortgage insurance costs borrowers money, but it enables them to become homeowners sooner by reducing the risk to financial institutions of issuing mortgages to people with small down payments. You might find it worthwhile to pay mortgage insurance premiums if you want to own a home sooner rather than later for lifestyle or affordability reasons. Adding to the reasons for doing this: Premiums can be canceled once your home equity reaches 80% if you’re paying monthly PMI or split-premium mortgage insurance.
However, you might think twice if you're in the category of borrowers who would have to pay FHA insurance premiums for the life of the loan. You might be able to refinance out of an FHA loan later to get rid of PMI. On the other hand, there's no guarantee that your employment situation or market interest rates will make a refinance possible or profitable.