The 20% down payment requirement is often considered the worst financial barrier to homeownership. While it is still possible to buy a home with less than 20% down, you will most likely have to purchase Private Mortgage Insurance.
In this article, you will learn:
- What PMI or Private Mortgage Insurance is
- How PMI works
- How much PMI will cost you
- How you can avoid PMI
What is Private Mortgage Insurance?
Private mortgage insurance, or PMI, is insurance coverage required by lenders when a borrower puts down less than 20%. Do not confuse it with homeowners insurance, which protects you in case your home is damaged.
While PMI is a type of insurance you as the borrower may have to pay for, it doesn’t protect you. Instead, PMI protects the lender and lowers lenders’ financial risk in case the borrower defaults. Indeed, PMI doesn’t save homeowners from foreclosure when their finances are under the water. But it allows individuals with limited cash on hand to obtain financing with a down payment of less than 20%.
How Much Does PMI Cost?
The cost of your PMI is determined by your total loan amount and the mortgage insurance rate, which typically hovers around 0.58% and 1.86%. For instance, if you buy a $400,000 house and put down 10%, your loan amount comes out to be $360,000. Your PMI would be around $2,088 to $6,696 a year or $175 to $558 per month based on this loan amount.
Generally, you will have to pay more PMI with a higher loan amount. On the other hand, the mortgage insurance rate is dependent on a few factors, such as your credit score, the type of loan, your loan term, and your loan-to-value ratio (LTV).
Your Credit Score
Your credit score plays a massive role in determining the cost of your mortgage PMI. The higher your credit score, the less risky you appear to lenders, making it easier for you to qualify for a lower PMI.
Type of loan
The type of loan you choose to take out also has an impact on your PMI. Fixed-rate mortgages are less risky, and less risk can mean a lower mortgage insurance rate. With adjustable-rate mortgages (ARMs), it’s harder to predict how the rates would go with adjustable-rate mortgages. From the lender’s perspective, this translates to a higher risk profile as the rates could go up significantly in the future. Therefore, you might get a higher mortgage insurance rate if you choose to go with ARMs.
Loan Term
The shorter the loan term, the less risky it is for the lender to give you a loan. 15-year fixed mortgages are less risky than 30-year fixed mortgages. So, if you’re planning on putting down less than 20% up-front, you could lower your mortgage insurance rate by choosing a shorter-term loan.
Down Payment or Loan to Value (LTV)
Your LTV goes hand in hand with the amount of down payment you can afford. A larger amount of down payment will give you a lower LTV. To put this in perspective, let’s go back to the $400,000 you want to buy. With 10% down, your loan amount comes out to $360,000, which brings your LTV to 90% ($360,000/$400,000). Higher LTV signals higher risks for the lender, and therefore they will likely require higher PMI.
How Do I Avoid PMI?
In many cases, you can avoid paying PMI altogether by paying the 20% down payment. However, avoiding the cost of PMIs is dependent mainly on the specific type of private mortgage insurance. Below are the two main types of PMI.
Borrower-Paid PMI
With borrower-paid private mortgage insurance, the costs are part of your monthly mortgage payments. Typically, the funds are distributed to the insurer each month. This payout generally is the “special payments” in your mortgage payment bill.
How To Avoid Borrower-Paid PMI (BPMI)?
Borrower-paid PMI is the most common private mortgage insurance. You can avoid BPMI altogether by paying a down payment of at least 20%. You can also request to have it removed when you build at least 20% equity in your home. Your BPMI will automatically end once you reach 22% equity in your home.
Lender-Paid PMI
While lender-paid private mortgage insurance may sound appealing, you’re still responsible for the premium payment. Instead of seeing the PMI as a line item on your loan estimate, you’ll likely deal with a higher interest rate or origination fee.
How To Avoid Lender-Paid PMI?
To avoid lender-paid private mortgage insurance, you can request that your lender pays your insurance premiums as a lump sum when you close on the loan in exchange for a higher interest rate. You can also choose to cover your entire PMI yourself at closing to avoid a higher interest rate. However, keep in mind that it is impossible to terminate lender-paid private mortgage insurance because your entire premium is paid as a lump sum upfront.
Before opting to avoid private mortgage insurance, you should ask your lender for solutions and do the math to see if it fits your financial and personal situation.
How to Get Rid of PMI?
There are a few things you can do to say goodbye to PMI.
- Make consistent payment until you achieve 20% equity in your home or an LTV of 80%.
- Your home value appreciates, and you now have 20% equity built up. You may have to reappraise your home to find out the current home value. If you discover that you owe less than 80%, it’s time to get in touch with your lender.
- You can make extra payments towards your loan at least for a few months. You can quickly pay down your principal by making additional payments and achieving an 80% LTV sooner than planned.
Though you may love the idea of getting rid of PMI as soon as possible, you should do your research, ask your lender some questions about your decision, and evaluate your finances.
Do All Lenders Require PMI?
Most lenders require borrowers to pay PMI for a conventional loan with a down payment of less than 20%. Still, you can find unconventional loan programs that allow you to avoid PMI even if your down payment is below the 20% threshold. However, you should stay alert because lenders are more likely to make up for the PMI by charging higher fees.
Now, you might be wondering if you can avoid PMI by going with government-backed loans. Let’s check out the two major government mortgage programs: FHA loan and VA loan.
FHA Loan
FHA Loan or Federal Housing Administration comes with Mortgage Insurance Premium (MIP) instead of Private Mortgage Insurance. FHA loans often come with an upfront MIP fee usually paid at closing and cost 1.75% of your total mortgage amount. And unlike PMI, there is no way to cancel your FHA loan MIP. So, you’ll have to deal with it all through the life of the loan.
VA Loan
VA Loan or Veteran Affairs Loan is a great way to avoid the payment of PMI. If you are a veteran, a VA loan offers some of the most lenient loan requirements. However, VA loans come with a funding fee of 1.4 to 3.6% of your total loan amount.
Conclusion
Whatever loan program you opt for ─ conventional or unconventional, lenders will most likely require a PMI or a similar fee if your down payment is below the required 20% mark. You should do your research and compare the total cost between putting down less than 20% and paying for PMI. Our Mortgage Payment Calculator can help you weigh the pros and cons.
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