What is PMI?
PMI stands for Private Mortgage Insurance. PMI is a risk-management tool required by lenders to protect themselves against loss of money when a borrower becomes unable to repay their mortgage.
When you purchase a home making a down payment of less than 20% or the value, most lenders require you to purchase PMI to insure them against any potential loss in case you are unable to repay your mortgage.
How Does it Work?
A mortgage insurance company (there are many – I like to use MGIC to obtain rate quotes) will issue a mortgage insurance policy naming the lender as the insured. For this you pay a premium that is based on a % of the total loan amount and can be anywhere from .28% to almost 2% of the total loan amount. The premium is added to your mortgage payment each month and becomes part of the formula lenders use to calculate your qualifying DTI.
Pros and Cons of Mortgage Insurance
Pro: Mortgage insurance is an extremely valuable tool that gives you a choice to purchase a home using a very small down payment…as little as 3%!
For example, you can buy a home valued at just under $500,000 ($499,330 to be exact) with 3% down and begin benefiting from the annual increase in value (appreciation). If you live in an area where homes increase in value by a modest 2% per year, at the end of your first year your $500,000 home has increase in value to $510,000. If your PMI payment is $200/month, then you’ve spent $2,400 to earn an increase in value of $10,000.
Con: Monthly PMI payments are added into your total monthly mortgage payment for qualifying purposes. This can increase your overall DTI to a level that your lender cannot approve. If this happens, I’ll analyze your overall financial situation and provide you with a game plan on how to bring your DTI back to within guidelines to get your loan approved.
How Do I Avoid PMI?
You have choices if you want to avoid payment PMI. The obvious choice is to contribute 20% down, but it may not be worth letting go of all that cash – just depends on your own financial situation.
If you have 10% cash available to contribute towards your down payment, another option is to borrow 80% of the home’s purchase price on a first mortgage, then add a HELOC (Home Equity Line of Credit) called a Piggyback arrangement in the amount of 10%. These arrangements allow you to avoid PMI by essentially financing half of your down payment as a junior (2nd) lien. Some HELOC’s offer interest only payment options but if you choose to make principal and interest payments on your HELOC, not only will you build equity in your home faster, but as you begin to pay down your HELOC balance, the credit line becomes available to use if you should need access to cash in the future.
How Do I Get PMI Removed?
If you choose to finance your home using PMI, you probably wonder how long you need to pay this insurance premium.
You can ask your lender to remove PMI when your loan amount reaches 80% of the original purchase price of your home. If you put 10% down and make regularly scheduled mortgage payments, it will take approximately 74 payments (or just over 6 years) to get to 80% LTV. If your home is appreciating in value quickly, it may be in your best interest to refinance your home loan to reset the loan to value, automatically eliminating your PMI.
Your lender MUST remove the PMI from your loan payment when your loan balance reaches 78% of the original purchase price of your home. If you put 10% down and make regularly scheduled mortgage payments, it will take approximately 86 payments (or just over 7 years) to get to 78% LTV.