Decoding PMI: Navigating Private Mortgage Insurance in Your Home Buying Journey
So, you’re diving into the world of home buying – exciting, right? But amidst the thrill of imagining your dream home, there’s this pesky term that keeps popping up: PMI insurance. Everyone’s got an opinion on it – “It’s a necessary evil”, “Avoid it like the plague”, “It’s an added cost!” – but what’s the real deal?
And what if you’re already saddled with PMI? Should you be in a hurry to shake it off? Let’s break it down and find out what all the fuss is about.
The PMI Puzzle: What’s the Buzz About?
Private mortgage insurance, or PMI, is insurance that the lender takes out on you in case you fail to pay your mortgage. It protects the lender when you stop making payments and are forced into foreclosure. Even though it is the lender that is getting the insurance against you, they still force you to pay it, which is a double whammy.
The need for PMI insurance is more apparent when a house is first bought and a mortgage is new. At this stage, there isn’t a lot of equity built into the house. Without the equity, the lender is not certain that if they take over the house then they will be able to sell it and recoup their loan.
Equity in a home is the amount that the house is worth and what you could sell it for, minus the amount you owe on the house.
If you bought a house that is worth $400,000, and you owe $380,000 on the mortgage, then you have $20,000 in home equity. If that same house went up in value to $450,000, then you would now have $70,000 in home equity.
As you can see, you can gain equity by having the home appreciate in value, and/or by paying down the loan.
PMI is not always required in a new mortgage. Lenders have drawn a line in what they consider enough equity in the home to drop the need for the insurance. That line is 20% home equity. If you put a down payment of 20% or more on a house, then you will have enough equity to no longer need PMI.
Most homebuyers, especially younger ones, are not going to be able to afford a 20% down payment. Even a “smaller” house at $200,000 would require a $40,000 down payment. This can be difficult to save outside of retirement accounts when you are just starting your career.
As you get older, it becomes easier to amass a 20% down payment. This is made even easier when you already have a home with substantial equity in it. You will be able to sell your current home and use the equity or cash you receive as the down payment.
Even though PMI is heavily unfavored, it does allow the flexibility to purchase a home with a smaller down payment. It is just that this flexibility comes at an added cost.
Crunching Numbers: How PMI Impacts Your Pocket
Lenders can pass the cost of PMI on to you in several ways. The most common way is to tack it on to your monthly payment. You can also opt to pay the PMI in a lump-sum at closing, or you can have the lender pay the PMI but take a larger interest rate.
On average, private mortgage insurance will cost 0.3% to 1.2% of the loan amount on an annual basis. The rate you are given will depend on several factors.
The larger your down payment, the less PMI will cost and the less risk there is to cover. The higher your credit score, the lower the PMI will be. Again, it is less risk to the lender if you come into the home purchase with a higher credit score.
The location of your home can also vary your PMI price. If the lender expects your home to appreciate in value, they understand that equity will rise quickly. The more equity you have in the home, the less risk to the lender because they can sell the house and recoup their investment. If your home is in a market with depreciating or stagnant home values, expect your PMI to be higher.
How you plan to use the home can also affect your PMI price. Rental homes and investment properties are riskier for the lender. If your financial situation goes south, it is much easier to ditch a rental home versus the home you currently live in.
MIP vs. PMI: Spotting the Difference
MIP, or mortgage insurance premium, is the equivalent to private mortgage insurance, but for government loans. If you are looking at using an FHA loan or reverse mortgage, you will be introduced to mortgage insurance premiums.
The rules regarding MIP are very similar to PMI, except for when trying to eliminate MIP. For one, you cannot eliminate MIP from an FHA loan issued since 2013. Once you have MIP on your FHA loan, it will be there for the life of the loan.
Kicking PMI to the Curb: Your Exit Strategy
When discussing PMI, we must understand the loan-to-value (LTV) ratio. As it sounds, this is the loan value to home value, and you can think of it as your equity in the home. If you have a loan of $80,000 out on a home that is valued at $100,000, then your LTV is 80%. If the home was valued at $200,000, your LTV would be 40%.
The lender wants to see an LTV of 80%. This is achieved by putting down 20%, having your home value appreciate, or by paying down your loan. If you are not at an 80% LTV, you shouldn’t consider eliminating your PMI.
Once your LTV does reach that magical 80% level, there are a couple of steps that you need to take to remove your PMI.
PMI will automatically be removed if the LTV falls to 78% based on your original home value. At this point, the lender will not consider the appreciation of your home value. Depending on your mortgage and payment, it typically takes around 5 years to pay down your mortgage enough to remove PMI.
If you feel that the value of your home has appreciated enough to give you an 80% LTV value, you will have to get your home appraised before getting PMI removed. You should go ahead and start the process with your lender, but understand that you will have to pay extra to get an appraisal. If you think your home value is right on the line to get you an 80% LTV, you may want to wait a little longer in case the appraisal value doesn’t come back at what you think. If the appreciation has happened in less than two years since the start of the loan, the lender will probably make you wait. Quick home value appreciation can be risky to the lender if that value disappears as quickly as it arrived.
Refinancing your loan can also be a method for removing PMI from your account. Again, you will need to get an outside appraisal done before being able to refinance your home, but it can come with the benefits of lowering your loan term or interest rate. However, you will have to pay closing costs and go through the same process as getting your original loan. If you are self-employed or don’t want to deal with the paperwork, this can be an extra hassle.
PMI: To Pay or Not to Pay Early?
Obviously, if your LTV is close to the 78-80% value, you want to consider taking steps to eliminate the PMI. If your LTV has dropped due to home value appreciation, you will have to weigh the costs of a home appraisal versus the value you think will come back for your home.
If you are not close to those LTV levels, does it make sense to go out of your way to pay down your loan to remove PMI?
To pay down your loan to remove PMI, you are going to have to bring in the extra cash from somewhere else. Let’s assume that you have extra cash flow that you can put into service by either paying down your loan or by investing it into the stock market.
To see if paying down PMI early is worth it, we need to look at the return of investment. Once we have the return of investment, we can compare that with the return on investment that we could receive by investing in the market.
There are a couple of caveats before we begin. First, every PMI situation is going to be different due to interest rates on the mortgage, how much PMI is, where you are on your loan, and what you are comfortable with when you invest in the market. Second, paying down PMI, like paying down a mortgage, is a guaranteed return whereas investing in the market is not. We can use the average returns of the market, but there is no guarantee of performance. Third, spending money on a mortgage is money that you will not get back. Investing in the market does give you liquidity to be able to sell your positions and take the cash back out.
Paying down your mortgage quickly will yield a higher return on investment in the short-run. Anytime you pay down your mortgage, you will increase the equity that you have in your home. If your home is worth $200,000 and you pay a 20% down payment, then you have $40,000 in equity in your home. If you only pay a down payment of 10%, then you will have $20,000 in equity in your home.
It is easy to see why, in the short-run, paying down your mortgage more quickly to remove PMI would have a higher return. The timeframe you would use would be the same as if you decided to pay down your mortgage normally and were able to remove PMI by getting your LTV down to that 78% – 80% level.
We say short-term because the longer your time frame, the worse the return on investment. The return begins to drop to a level that is around the interest rate you have on your mortgage. If you look at paying down your mortgage early over the 30 years it takes to pay off a mortgage, then the return on investment falls.
Actionable Steps to Navigate PMI:
- Educate Yourself: Before diving into the home buying process, understand what PMI is, its benefits, and its drawbacks.
- Evaluate Your Finances:
Determine if you can afford a 20% down payment to avoid PMI.
If not, calculate the additional monthly cost of PMI using the average range of 0.3% to 1.2% of the loan amount annually. - Shop Around:
Different lenders may have varying PMI rates or offer loans without PMI.
Discuss with mortgage brokers or direct lenders about your options. - Consider FHA Alternatives:
If you’re considering an FHA loan, remember the MIP (which is akin to PMI) that comes with it. Weigh the pros and cons. - Regularly Monitor Home Equity:
As you pay off your mortgage and as your property potentially appreciates, your equity increases.
Use online home value estimators or consider periodic professional appraisals to monitor this. - Request PMI Removal:
Once you believe you’ve hit the 20% equity threshold (80% LTV), contact your lender.
You might need a professional appraisal. Factor in this cost when deciding the right time to request PMI removal. - Refinance If Beneficial:
If interest rates have dropped or your credit has improved, you might benefit from refinancing.
Refinancing can also help you get rid of PMI if you’ve built enough equity in your home. - Review Your Mortgage Statement:
Lenders are required to terminate PMI once a loan reaches 78% LTV, but it’s a good idea to keep an eye on this yourself.
If you notice you’re at this point but are still being charged PMI, contact your lender immediately. - Invest Wisely:
If you’re considering paying down your mortgage faster to eliminate PMI, compare the potential returns with other investment opportunities.
Remember, while paying down your mortgage offers a guaranteed return (in the form of saved interest and PMI), investing in the market doesn’t. Weigh the risks and potential returns. - Stay Informed:
Real estate and lending landscapes change. New policies, market trends, or lending products can affect PMI and home equity.
Periodically review current information to make informed decisions about your mortgage and PMI.
Conclusion
So, here’s the scoop on PMI. If you’ve got it, it’s not the end of the world. While in the short run, it might seem tempting to pay it down pronto, in the grand scheme of things, like over a 30-year mortgage, the urgency dims. PMI will naturally drop off as you build equity, either through payments or rising home values. While the immediate returns might seem appealing, it’s essential to zoom out and see the bigger picture. After all, home buying is a marathon, not a sprint. So, breathe easy, evaluate your options, and remember – every home journey is unique, just like yours.
Glossary:
PMI (Private Mortgage Insurance): An insurance policy taken out by the lender that protects them if the borrower stops making mortgage payments. It’s typically required when a borrower doesn’t put down at least 20% on a home.
Equity: The difference between the market value of a property and the amount owed on it. As equity increases, the financial stake the owner has in the property becomes greater.
Down Payment: The initial sum of money a buyer pays towards the purchase price of a property. The remainder is then mortgaged.
MIP (Mortgage Insurance Premium): Like PMI, but specifically for government-backed loans like FHA loans. MIP is typically required for the life of the loan.
FHA Loan: A mortgage issued by federally qualified lenders and insured by the Federal Housing Administration.
Appraisal: An evaluation process to determine the market value of a property, typically conducted by a professional appraiser.
LTV (Loan-to-Value) Ratio: The ratio between the amount borrowed and the appraised value of the property. It’s a key metric used by lenders to measure the risk of a loan.