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, if you're taking out a conventional mortgage. The purpose of the insurance is to protect the mortgage company if you default on the note.
The FHA has a similar mortgage insurance premium requirement for those taking out FHA mortgages, with somewhat different rules. This article is about PMI, but the reasons to avoid it generally apply to both types of loans.
PMI sounds like a great way to buy a house without having to save as much for a down payment. Sometimes it is the only option for new homebuyers. However, there are good reasons why you should try to avoid needing PMI. Here are six, along with a possible way for those without a 20% down payment to sidestep it altogether.
Six Good Reasons to Avoid Private Mortgage Insurance
- Cost – PMI typically costs between 0.5% to 1% of the entire loan amount on an annual basis. This means that on a $100,000 loan you could be paying as much as $1,000 a year – or $83.33 per month – assuming a 1% PMI fee. However, the median listing price of U.S. homes, according to Zillow, is $261,500 (as of Feb. 28, 2018), which means families could be spending as much as $218 a month on the insurance. That’s as much as a small car payment!
- No Longer Deductible – For 2017 PMI is still tax deductible, but only if a married taxpayer’s adjusted gross income is less than $110,000 per year. This means many dual-income families will be left out in the cold. The recent Tax Cuts and Jobs Act ended the deduction for mortgage insurance premiums entirely, starting in 2018.
- Your Heirs Get Nothing – Most homeowners hear the word “insurance” and assume that their spouse or 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 PMI until the total equity of the home reaches 20%. This could take years, and it amounts to a lot of money you are 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 your equity tops 20%, you no longer have to pay PMI. However, eliminating the monthly burden isn’t as easy as just not sending in the payment. Many lenders require you to draft a letter requesting that the PMI be canceled and insist upon 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. PMI isn’t automatically canceled until your equity hits 22%. (For more, see How to Get Rid of Private Mortgage Insurance.)
- Payment Goes On and On – One final issue that deserves mentioning is that some lenders require you to maintain a PMI contract for a designated period of time. So, even if you have met the 20% threshold, you 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 PMI
In some circumstances PMI can be avoided by using a piggy-back mortgage. It works like this: If you want to purchase a house for $200,000 but only have enough money saved for a 10% down payment, you can enter into what is known as an 80/10/10 agreement. You will take out one loan totaling 80% of the total value of the property, or $160,000, and then a second loan, referred to as a piggyback, for $20,000 (or 10% of the value). Finally, as part of the transaction, you put down the final 10%, or $20,000.
By splitting up the loans, you may be able to deduct the interest on both of them 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 the more standard 30-year mortgage).
The Bottom Line
PMI 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 more, see How to Outsmart Private Mortgage Insurance.)
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