Understanding Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) is a special type of insurance policy, provided by private insurers, to protect a lender against loss if a borrower defaults. Most lenders require PMI when a homebuyer makes a down payment of less than 20% of the home's purchase price – or, in mortgage-speak, the mortgage's loan-to-value (LTV) ratio is in excess of 80% (the higher the LTV ratio, the higher the risk profile of the mortgage).
PMI allows borrowers to obtain financing if they can only afford (or prefer) to put down only 5% to 19.99% of the residence's cost, but it comes with additional monthly costs. Borrowers 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 0.25% to 2% (but typically run about 0.5 to 1%) of your loan balance per year, depending on the size of the down payment and mortgage, the loan term and your credit score. The greater your risk factors, the higher the rate you pay. Also, because PMI is a percentage of the loan amount, the more you borrow, the more PMI you’ll pay. There are six major PMI companies in the United States. They charge similar rates, which are adjusted annually.
Protecting the Lender
Why is 20% the magic number? It arose from the notion that many lenders believe, in most cases, they can get 80% of the value of a home at a foreclosure auction. Mortgage insurance is not designed to protect the borrower in any way. It protects the lender from incurring losses in the event of a mortgage default.
For example, if a borrower were to make a 5% down payment, the lender would work with a mortgage insurance provider to provide coverage for the remaining 15%. In theory, if a borrower were to default, the bank could recover roughly 80% of the home's value in an auction, 15% of the value from mortgage insurance and the original 5% down payment. While PMI can't guarantee total protection against losses for the lender, it is designed to help lenders recover most of its invested capital in the instance of default.
How Long Do You Carry 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 drops to 78% – meaning your down payment, plus the loan principal you’ve paid off, equals 22% of the home’s purchase price – the lender must automatically cancel PMI as required by the federal Homeowners Protection Act, even if your home’s market value has gone down (as long as you’re current on your mortgage).
Types of PMI
There are three different types of private mortgage insurance:
1. Borrower-Paid PMI (BPMI). You pay a premium every month until your PMI is either terminated (when your LTV balance is scheduled to reach 78% of the original value of your home), or when it is canceled at your request. Generally, when a borrower has achieved 20% equity in the home, he can notify the lender in writing that it is time to discontinue the PMI premiums.
Lenders are required give the buyer a written statement at closing notifying them how many years and months it will take for them to pay 20% of the mortgage principal, but it could happen sooner, due to home-price appreciation (verified by an appraisal) or because you’ve made additional principal payments. The lender should comply as long as your home’s value hasn’t dropped, you have a history of on-time payments and you certify that you don't have a second mortgage or subordinate lien on the property. You can also request cancelation or when you reach the midpoint of the amortization period (a 30-year loan, for example, would reach the midpoint after 15 years).
2. Single Premium PMI. You pay the mortgage insurance premium upfront in a single lump sum, eliminating the need for a monthly PMI payment. The single premium can be paid in full at closing or financed into the mortgage. While it requires more of an initial outlay, this option can save money for long-term homeowners.
3. Lender-Paid PMI (LPMI): The lender pays the private mortgage insurance on behalf of the borrower. This can make for a lower monthly mortgage payment, but you may end up paying more in interest over the life of the loan, especially since the rates are usually higher for this sort of PMI (since its cost is included in the mortgage interest rate for the life of the loan). Unlike BPMI, you cannot cancel LPMI, because it is a permanent part of the loan.
With BPMI, it's important to keep track of your mortgage payments and your equity buildup. That 78% threshold for automatic termination is based on the date that the LTV is scheduled to reach 78%, according to your amortization schedule, not on your actual payments. That means that if you made extra payments and reached the 78% threshold ahead of schedule, your lender does not have to terminate PMI until the originally scheduled date, which could leave you making months – or even years – of unnecessary PMI payments. (By law, lenders are required to inform you of your general right to cancel PMI, but not when you in particular can.)
Nor should you count on the lender to be aware that your equity in the property has reached 20% of its original purchase price or current appraised value. If it has, then the onus is on you to request cancelation. To request cancelation, you must be current on your mortgage payments and have a good payment record; specifically, that you have:
- not made a payment that was 60 days or more past due within the first 12 months of the last two years prior to the cancelation date (or the date that you request the cancelation, whichever is later)
- not made a payment that was 30 days or more past due within the 12 months prior to the cancelation date (or the date that you request the cancelation, whichever is later)
Paying down your mortgage isn’t the only way to build the equity that permits you to request a cancelation. Making improvements that add enough value to your home can also bring you to the required minimum. If you are doing a big renovation – a significant kitchen remodeling, for example – review the numbers to see if you now qualify for a written PMI cancelation request.
Once PMI has been canceled, the lender can't require further PMI payments more than 30 days after the date your written request was received, or the date that you satisfied the evidence and certification requirements, whichever is later.
PMI Versus MIP: the Difference between Private Mortgage Insurance and Mortgage Insurance Premium
FHA loans are similar to PMI loans in that they require mortgage insurance to be paid by the borrower, on top of the regular mortgage payments. But this insurance, known as the mortgage insurance premium (MIP), requires an up-front fee at closing, as well as a monthly premium, for a set number of years; it is paid directly to the U.S. Department of Housing and Urban Development (HUD). FHA loans also differ in that they are available to borrowers with less-than-perfect credit, allow down payments of as little as 3.5% of a home's purchase price, and cannot be used for investment or secondary residences.
There is another big difference: MIPs are often for life, under HUD statutes revised a few years ago. If you take out an FHA loan in 2017, with a down payment below 10%, you will not be able to cancel your annual mortgage insurance premium until the end of the loan’s term or the first 30 years of the term, whichever comes first. If your original LTV is 90% or less (meaning your down payment was in the 10%-20% range), you'll pay MIP for 11 years.
If your loan originated prior to June 3, 2013, the MIPs are often discontinued under the same conditions as PMIs. However, your lender may be legally entitled to continue requiring them on your FHA loan under several circumstances:
- When you made payments over 30 days late within the previous year and over 60 days late within the last two years, your lender can continue to consider you a high-risk borrower. Your lender can come to the same conclusion when your current credit score is very low.
- If you have a second mortgage, such as a home equity loan, on your property. The thinking is, if you have a higher debt-to-loan ratio, you are more likely to default on your obligations.
- The worth of your home has dropped dramatically from when the FHA loan was first issued, so that your LTV remains 80% or higher using its current market value.
What Influences PMI Rates?
- Size of your down payment: PMI will cost less if you have a larger down payment (and vice versa).
- Your credit score: The higher your credit score, the lower your PMI premium.
- Potential for property appreciation: If you live in a market with declining property values, your PMI premium might be higher.
- Loan type: Adjustable-rate mortgages (ARMs) require higher PMI payments than fixed-rate mortgages.
- Borrower occupancy: If the financed property will be owner-occupied (you will be living there), your PMI premium will be lower than if it is a rental or investment property.
Assume you have a 30-year 4.5% fixed-rate mortgage for $200,000. Your monthly mortgage payment (principal plus interest) would be $1,013. If PMI costs 0.5%, you would pay an additional $1,000 per year, or $83.33 each month, bringing your monthly house payment up to $1,096.70.
In many cases, the single premium PMI is the more affordable option as long as you plan on staying in the home for at least three years. For the same $200,000 loan, you might pay about 1.4% upfront, or $2,800 (compared to around $3,000 after three years with monthly PMI payments).
How to Avoid Private Mortgage Insurance
Whatever type you choose, PMI is not cheap. (And don't confuse it with with mortgage life insurance, which goes to you, or your heirs, to pay off your mortgage if you become disabled or die. The lender is the sole beneficiary of PMI.) But ways to avoid it do exist.
An alternative to paying PMI is to use a second mortgage or piggyback loan. In doing so, the borrower takes a first mortgage with an amount equal to 80% of the home value, thereby avoiding PMI, and then takes a second mortgage with an amount equal to the sales price of the home minus the amount of the down payment and the amount of 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.
Of course, there is a drawback: A second mortgage in most cases will carry a higher interest rate than the first mortgage.
How to decide between these two basic options – to use a "stand-alone" first mortgage and pay PMI or use a second mortgage? There are several variables that can play into this decision, including:
- The monthly numbers: Are the combined payments of the first and second mortgage less than the payments of the first mortgage plus PMI?
- The tax savings associated with paying PMI verses the tax savings associated with paying interest on a second mortgage. Tax law in the United States allows for the deduction of PMI for specific income levels only, such as families that earn less than $100,000. In contrast, there are usually no restrictions on deducting regular mortgage interest.
- The different rates of principal reduction of the two options.
- The time value of money.
However, the most important variable in the decision is:
- The expected rate of home price appreciation
For example, if the borrower chooses to use a stand-alone first mortgage and pay PMI versus using a second mortgage to eliminate PMI, how quickly might the home appreciate in value to the point where the LTV is 78% and the PMI can be eliminated? This is the overriding deciding factor.
Appreciation: The Key to Decision-Making
The key to the decision is that once PMI is eliminated from the stand-alone first mortgage, the monthly payment will be less than the combined payments on the first and second mortgages. So we ask the questions: "How long will it be before the PMI can be eliminated?" and "What are the savings associated with each option?"
Below are two examples based on different estimates of the rate of home price appreciation.
Example 1: A Slow Rate of Home Price Appreciation
The tables below compare the monthly payments of a stand-alone, 30-year, fixed-rate mortgage with PMI versus a 30-year fixed-rate first mortgage combined with a 30-year/due-in-15-year second mortgage.
The mortgages have the following characteristics:
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In Figure 2, the annual rates of home price appreciation are estimated.
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Notice that the $120 PMI payment is dropped from the total monthly payment of the stand-alone first mortgage in month 60, as shown in Figure 3, when the LTV reaches 78% through a combination of principal reduction and home price appreciation.
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The table in Figure 4 shows the combined monthly payments of the first and second mortgages. Notice that the monthly payment is constant. The interest rate is a weighted average. The LTV is only that of the first mortgage.
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Using the first and second mortgage, $85 dollars can be saved per-month for the first 60 months. This equals a total savings of $5,100. Starting in month 61, the stand-alone first mortgage gains an advantage of $35 per month for the remaining terms of the mortgages. If we divide $5,100 by $35, we get 145. In other words, in this scenario of slow home price appreciation, starting in month 61, it would take another 145 months before the payment advantage of the stand-alone first mortgage without PMI could gain back the initial advantage of the combined first and second mortgages. (This time period would be lengthened if the time value of money were considered.)
Example 2: A Rapid Rate of Home Price Appreciation
The example below is based on the same mortgages as demonstrated above. However, the following home price appreciation estimates are used.
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In this example, we only show a single table of monthly payments for the two options (see Figure 6). Notice that PMI is dropped in this case in month 13 because of the rapid home price appreciation, which quickly lowers the LTV to 78%.
With rapid home price appreciation, PMI can be eliminated relatively quickly. The combined mortgages only have a payment advantage of $85 for 12 months. This equals a total savings of $1,020. Starting in month 13, the stand-alone mortgage has a payment advantage of $35. If we divide $1,020 by 35, we can determine that it would take 29 months to make up the initial savings of the combined first and second mortgages. In other words, starting in month 41, the borrower would be financially better off by choosing the stand-alone first mortgage with PMI. (This time period would be lengthened if the time value of money were considered.)
One More Option: Refinancing
After a few years, homeowners may have another option to get rid of PMI: refinancing. If you think your home's value has appreciated, a new loan may account for less than 80% of the home's value, meaning you will not have to pay PMI. While this can help homeowners, it's important to do some numbers-crunching beforehand to make sure that refinancing makes financial sense. Interest rates might have risen substantially since your purchase, for example. In general, if you can refinance at a favorable, lower-interest rate and get rid of PMI at the same time, it might be a good move.