As you consider homeownership, you'll encounter a sea of terms that sound more like alphabet soup than finance. PMI or Private Mortgage Insurance often pops up, especially when you're not making a hefty down payment. This little acronym can make a big difference in your monthly payments. Let's demystify PMI and explore its ins and outs!
What is Private Mortgage Insurance?
Private mortgage insurance is a type of insurance product that protects the lender. As the home buyer, you purchase and pay towards it with your monthly mortgage payments. If you stop making payments and default on the loan, the lender can file a claim with the insurance company to recoup some of its losses.
Typically, you only need to purchase PMI if you put down less than 20% on the home purchase. If you put down 20% or more, the lender isn't likely to require this additional insurance because you're less likely to default on the loan.
How Does PMI Work
There are numerous things to know about PMI. The first is that the home buyer pays for this insurance product, but the protection is for the lender. If you default on the loan, the lender has access to funds to recoup some of its losses in your loan. However, PMI does not, in any way, protect you from foreclosure.
PMI and Loan-to-Value Ratio
One factor determining if you need PMI is the loan-to-value ratio or your mortgage when you purchase a home. Specifically, this is the ratio between the home's value and the home's purchase price. The higher this ratio is, the more likely you will need PMI.
For example, if you wish to purchase a home for $400,000 and have a down payment of $20,000, you're only putting 10% down. The loan-to-value ratio here is very high – 90%, which puts a lot of risk on the lender. The requirement, then, is that you'll likely need PMI, and you'll need to purchase enough PMI to offset that risk.
By contrast, if you put down $40,000 in cash on the purchase, the lender only finances 80% of the home's value, which is much less of a risk factor for the lender, meaning less need for PMI.
The Cost of PMI
The price of PMI depends on the loan amount. On average, it ranges between 0.46% and 1.5% of the amount you borrow to purchase the home, but this can vary among lenders.
Additionally, your PMI cost is influenced by your down payment. The more you put down, the lower the risk for the lender, leading to a reduced PMI cost.
Determining the exact PMI cost might seem daunting, but you can get an estimate when applying for the loan. Your lender will provide an expected cost based on the amount you intend to borrow, your down payment, and your credit score. Some lenders offer lower PMI rates to borrowers with higher credit scores.
PMI Cancellation
Did you know you can eventually cancel PMI? Federal law mandates lenders to terminate your PMI coverage when your loan-to-value ratio hits 78%. So, when you accumulate 22% equity in the home, lenders should automatically remove this charge.
Additionally, when you achieve a loan-to-value ratio of 80%, indicating you've paid 20% of the loan, you can ask your lender to cancel PMI. Moreover, suppose an updated appraisal shows an increase in your home's value, that brings you to that 20% threshold. In that case, you can request your lender to remove the PMI obligations.
Alternatives to PMI
There are a few ways you can avoid PMI. The first is to make a down payment of at least 20% of the home's purchase price (as long as that's 20% of the home's value). If that doesn't work, you can also seek out a piggyback loan. These loans, sometimes called an 80/10/10 loan, will provide a loan worth 80% of the home's purchase price and then 10% of the home's purchase price. The remaining 10% is your down payment. It can get expensive, though, so you'll want to determine what makes the most sense for you – the piggyback loan (if a lender approves it) or just paying PMI.
Also, note that you do not have to pay PMI if you have a VA loan. That's always a good option for those who are current or former members of the U.S. Armed Forces.
PMI Tax Deductibility
For tax years 2018 through 2021, you could deduct PMI from your income tax. However, as of tax year 2023, the tax deductibility of PMI remains undecided. The tax deduction for PMI expired in 2022, and lawmakers have not renewed it yet.
Takeaways
Paying PMI is not uncommon, but understanding why you have to pay it and what it means to do so is critical before you enter into a long-term mortgage. In every situation, you can eliminate the need for this added monthly cost by simply making a 20% down payment to purchase your home. That's easier said than done for many people, though. Don't let PMI stand in the way of your home ownership goals.