Are You Worried About PMI Insurance?
You are in the market for a new home, but you keep hearing about PMI insurance.
You are unsure what it is, but people tell you it will add to the cost of the home and you should avoid it at all cost.
What about if you already have PMI insurance on your home, should you try to get rid of it as quickly as possible?
People worry a lot about PMI insurance but is it really all bad? Should you really strive to get it off your loan as quickly as possible?
What is Private Mortgage Insurance
Private mortgage insurance, or PMI, is insurance 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, they will be able to sell it and recoup their loan.
Equity in a home is the amount the house is worth, 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, you have $20,000 in home equity. If that same house went up in value to $450,000, 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, 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 just that flexibility comes at an added cost.
How is PMI Calculated
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. The larger the down payment, 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.
Is MIP Similar to PMI
MIP, 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 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.
How to Remove PMI
When discussing PMI, we must understand the loan-to-value (LTV) ratio. As it sounds, this is the loan value to home value, you can think of it as your equity in the home. If you have loan of $80,000 out on a home that is valued at $100,000, 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 magically 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 you 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. 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.
Should You Remove PMI
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 they 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 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 rate 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 while investing in the market is not. We can use 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 the mortgage quickly will yield a higher return on investment in the short run. Anytime you pay down your mortgage, you will increase the equity you have in your home. If your home is worth $200,000, you pay a 20% down payment, you have $40,000 in equity in your home. If you only paid a down payment of 10%, 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 be 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%.
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 on your mortgage. If you look at paying down your mortgage early over the 30 years it takes to pay off a mortgage, the return on investment falls.
If you currently have private mortgage insurance, it may be better to keep paying it rather than trying to pay it down early. You will only have to pay PMI while your LTV is above the 78-80% level. Once you have paid off enough balance or your home value appreciates, PMI will come off your loan.
Paying down your loan early to remove PMI looks great in the short-term. The return on investment will be attractive enough to want to make that move. However, if you look at your rate or return in terms of the entire loan, you will notice the return on investment does fall back to normal levels. Getting rid of PMI 3-5 years early by spending extra cash, doesn’t look as good when looking over the entire 30-year term.