Understanding Private Mortgage Insurance

There are plenty of costs involved in buying a house. While a downpayment is certainly the biggest one, there are no shortage of other one-time fees and ongoing expenses. Private mortgage insurance–also known as PMI–is often one of them. Whether or not you need private mortgage insurance, and how much it will cost you, will depend on a number of different factors. If you are in the market for a home, it is therefore important that you take the time to understand private mortgage insurance.

Unlike most insurance products, such as health, auto, or homeowners insurance, PMI is not designed to help you offset a major expense if an incident occurs. Instead, it is meant to provide protection to your lender in the case that you are not able to repay your loan obligations.

What is Private Mortgage Insurance?

PMI is an insurance product that covers lenders in the case of a default. In other words, it exists to serve as a protection for financial institutions against the failure to repay a mortgage. The institution providing the PMI will pay the lender at least a portion of any outstanding mortgage obligations if the borrower defaults.

PMI is therefore often associated with mortgages that are considered somewhat riskier loans. In practice, for conventional mortgages, those whose downpayment is less than 20% of the total cost of the home will be required to purchase PMI.

The reason is fairly straightforward, as those with smaller downpayments will have a significantly larger mortgage to repay in the years to come. On the flip side, those who have paid off a larger chunk of the cost of their home with the initial downpayment have demonstrated the means to make larger payments right off the bat, and are therefore seen as a safer bet to repay their obligations on time and in full.

Therefore, the cost of the PMI that you will pay is dependent on the amount of your downpayment, the size of the rest of your loan obligation, and your credit score. In general, it will cost annually somewhere in the range of 0.5% to 1.5% of the initial loan amount.

How to Think About PMI

PMI offers one major advantage, in that it enables lenders to offer loans to riskier borrowers. This can make home ownership more achievable for those without the means to make a larger downpayment.

The cost, of course, is that it adds to the monthly expenses for homeowners. This can certainly add up over time, and will make the overall cost of a mortgage more expensive. (You can refer to TipRanks’ mortgage calculator to understand the full contours of your mortgage and added cost of PMI over time.)

In practice, your lender will decide on the PMI provider, and in most cases a portion of your monthly mortgage payments will be sent automatically to them. (In other words, this will not be a separate payment that you will be responsible for.)

Not all mortgages–even those with minimal downpayments–require PMI. For instance, a VA Home Loan does not require mortgage insurance. FHA-guaranteed loans do not have PMI, though they do require a mortgage insurance premium that includes an upfront cost of 1.75% of the price of your house as well as an annual fee that most lenders will charge on a monthly basis.

Can PMI Be Eventually Removed?

The quick answer is that YES, PMI does not need to accompany you forever. Once you have accumulated at least 20% equity in your home, you can request the removal of PMI. In addition, PMI will automatically be removed once your loan-to-value (also known as LTV) ratio hits 78%.

LTV is the amount of your outstanding loan divided by the value of your home X 100. Because home values change over time (usually up, as prices rise), this is not always the same as the sticker price you paid when you signed the initial purchasing papers.

In some cases, however, PMI remains with you throughout the life of your mortgage. For instance, some individuals have what’s called Lender-Paid Mortgage Insurance (LPMI). According to this arrangement, the lender will pay the mortgage premiums in exchange for a higher interest rate on the financing. Because the insurance premiums are essentially part of the interest rates, the only way to remove LPMI is by refinancing your mortgage.

Don’t forget, when you refinance your mortgage, or take on a Home Equity Line of Credit (HELOC), you are once again taking on a debt obligation based on the equity you have accumulated. This could cause your LTV to dip under 20%, in which case you would once again be on the hook for purchasing PMI.

Conclusion: PMI and Your Financial Journey

Purchasing a home is a huge commitment, financial and otherwise, and requires a full, 360 degrees understanding of both your finances and the design of the life you wish to lead. PMI, all things considered, is not such a large expense, especially when compared to the overall cost of a home. And yet, it is a cost that needs to be taken into account when weighing your homebuying choices.

If you run the numbers and discover that PMI pushes you over your limit, it might be a sign that you should think about either finding a cheaper home (where you can pay off a larger segment of your mortgage) or continuing to save for a down payment. Alternatively, if paying for PMI is not a dealbreaker for you, proceed with the knowledge that it exists to help you purchase a home with financing that a lender might otherwise have not agreed to provide.

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