What it is and why it exists
What is PMI
Private Mortgage Insurance (PMI) is required on all loan transactions where the loan-to-value ratio is 80 percent or greater. (Some cash-out refinance transactions require PMI at 75% loan-to-value.) This means that if you bought your house for $100,000 and had a down payment of less than $20,000, you will be required by the lender to carry PMI.
Private Mortgage Insurance insures the lender – not you – against your default on the loan. Because statistics show that borrowers who put down less than 20 percent are more likely to default on the loan, lenders require PMI so that they’ll recoup their investment in case of default. Without the guarantee from carrying the PMI, the lender would not make the loan, but they’re willing to take the risk as long as you carry PMI. As a borrower this may provide you with a lower interest rate loan than you could originally obtain, but the mortgage insurance premium (MIP) may not be saving you any money in the end.
How do you get rid of PMI?
Private Mortgage Insurance is of concern to the borrower because, unlike mortgage interest, PMI is not tax deductible. You pay it and you never see a dime of it again. For this reason, you will want to get rid of it as soon as possible.
When can you stop paying PMI? The lender cannot force you to keep the PMI once the loan- to-value has gone below 80 percent, however, the lender will not advise you when you are eligible to discontinue the coverage and stop making that mortgage insurance premium (MIP) payment. So what you want to do first is to take a look at your most recent mortgage statement and divide the remaining principal balance by the original purchase price of your home. If that number is below 80 percent, call the lender and find out their procedure for removing PMI. It is the responsibility of the borrower to track the debt to value ratio and make all the arrangements to stop the PMI coverage.
It is important to note that even if you haven’t been paying on the loan for very long, you still may qualify for having PMI removed by virtue of appreciation. This occurs when the value of your home increases shortly after you have purchased it. The lender probably will require a full appraisal, which will typically cost you approximately $300. But you will quickly recover this cost by not having to pay the MIP and therefore canceling the PMI. After the cost is recovered, the amount you were spending on PMI goes in your pocket. You can also pay a little extra each month toward the principal to reduce your loan balance and shorten the time you must pay PMI.
How can you avoid paying PMI?
There are ways of both avoiding Private Mortgage Insurance and achieving a smaller than 20 percent down payment. Many lenders offer a loan called an “80/10/10.” Instead of one loan, you get two. You’ll have a first mortgage of 80 percent of the home’s value, a second mortgage of 10 percent of the home’s value, and you’ll make a 10 percent down payment. Some lenders may even offer an 80/15/5. This may seem complicated, since you’re still borrowing the same amount of money, but the lender in the “first position” is only lending 80 percent of the entire loan amount, which is less of a risk than the full loan amount. You get the small down payment and the tax-deductible interest. In addition, the total monthly payments are often smaller than one larger loan with PMI.
The other way out is to get a loan that builds the PMI into the interest rate. In this case, you agree to pay a higher interest rate in exchange for the lender loaning you more money than they normally would. It can be a nice compromise, because the interest is still tax deductible and it’s simpler than doing two loan transactions. The key here is comparison. Ask your loan agent for some mortgage insurance advice. Have them run some numbers for you on an 80/10/10 and a loan with built-in PMI. Then see which one will cost less or be most beneficial based on your financial situation.
Note that these principles apply only to conventional loans. FHA loans have a Mortgage Insurance Premium (MIP), which is required for the life of the loan.