Most people do not know what private mortgage insurance is until they are ready to close on their new home. If you purchased a home and you put less than 20 percent of the appraised value down on the home, than it is likely you have this insurance. But what exactly is it and what does it do?
Knowing the Basics
Private mortgage insurance, or PMI, is an insurance product that protects the lender if the borrower defaults on the mortgage and they cannot recoup the full value of the loan with the sale of the house. PMI lowers the risk that bank takes on the borrower, allowing them to extend mortgages to people who do not have large down payments.
Most lenders will require that borrowers who put less than 20 percent down pay PMI as part of their mortgage. While it varies, usually you will pay between a half and one percent of the mortgage value for PMI. On a mortgage that is $100,000, you will pay an annual premium between $500 and $1000.
Paying Off Your Mortgage
As you pay down your mortgage, you are closer to not being required to carry PMI on your home. In fact, by law, a lender has to allow you to drop the private mortgage insurance once your mortgage balance reaches 80 percent of the appraised value of your home. While a lender does not have to drop PMI at 80 percent, they are required to drop the premiums before the balance hits 78 percent of the value of the home.
In some instances, lenders are able to require borrowers to carry PMI until the mortgage balance reaches 50 percent of the appraised value. This is typically only done in high risk cases, such as bad credit, no doc loans, high debt-to-income ratios or loans that require very little verification. Lenders are also required to tell you at closing when you are able to cancel PMI on your loan.
Avoiding PMI from the Start
If at all possible, as a borrower, you will want to avoid private mortgage insurance at all costs, because it does cost you a lot of extra money each month. You can typically avoid PMI with 20 percent down, but not everyone has that much money saved up to purchase a home. But there are other ways around the insurance.
One way to do this is by taking out a second mortgage at closing. Say you have a 10 percent down payment, but want to avoid the PMI. You can take out a mortgage for the 80 percent of the value and then take out a second mortgage that covers the other 10 percent you need to purchase the home. While the interest rate on the second mortgage will be a little higher, it will be cheaper than carrying private mortgage insurance.
The other way that you can avoid it is to take a higher interest from the lender. Over the life of the loan, you will pay much more interest if you go this route, but you can always refinance once you hit the 80 percent mark. Also, the advantage to taking the higher interest rate is that it is tax deductible, while insurance premiums are not.