Here at Solutions, we often get asked lots of questions by first time homebuyers about all the acronyms that get thrown around by lenders when preparing an offer.
For one example, what is PMI?
Basically, it’s a protection for a lender. When your down payment is less than 20%, you usually have to pay for Private Mortgage Insurance, (PMI), which is the lenders’ (banks’) protection in the event that you default on your primary mortgage and no longer make payments and the home ends up going into foreclosure.
Paying private mortgage insurance is often a necessary cost if you want to purchase a home without a significant down payment, but you need to understand the terms of your current mortgage contract and calculate your loan to value ratio to avoid paying it longer than absolutely necessary.
Knowing when and how to remove PMI will lower your monthly mortgage bill. Follow the tips below and the next time you apply for a mortgage, make sure you understand the PMI rules and ask for clarification before signing.
Does everyone need to pay it?
Private mortgage insurance is an actual insurance policy issued by an insurance company that benefits your lender. Essentially, your lender is requiring you to pay the premiums for an insurance policy that partially reimburses them should you default on your mortgage.
PMI is called “private” because it’s only offered to private companies and not government agencies or public mortgage lenders. Public programs, such as the FHA and VA mortgage programs, have their own mortgage insurance, but it’s run differently and managed internally.
One notable difference, however, between PMI and mortgage insurance attached to many FHA and VA loans is that the latter never expires. In other words, you will continue paying mortgage insurance on FHA and VA loans even after your loan to value ratio has dropped below 80%.
If your home goes into foreclosure and the lender isn’t able to recoup the outstanding balance by selling the home, the insurance company that issued your PMI will pay the lender the difference.
Since foreclosed upon homes are often sold at a “discount,” lenders want a buffer of at least 20%. When applying for a home loan, lenders typically require that a borrower provides a 20% down payment on the home. If the borrower is unable to do so, or doesn’t have the required funds to do so, then lenders will typically look at the loan as a riskier investment for their balance sheet and will require a PMI payment from the borrower.
This is usually paid monthly as part of the overall mortgage payment to the lender. Over several years of paying on the loan and once the borrower has paid enough towards the principal amount of the loan (to cover the 20%), they can contact their lender and ask that the PMI payment be removed.
Many borrowers either forget or don’t know that PMI can be removed once the accepted level is achieved.
Loan to Value (LTV) Ratio
The loan to value (LTV) ratio is what the lender looks at to determine whether or not you need to pay PMI, and when you can stop paying it. To calculate this ratio, take the amount of the loan and compare it to the current value of your house.
For example, if your mortgage is $150,000 and your home is currently worth $200,000, your loan to value ratio is 75%.
When you buy a new home, your lender will look at the amount of your down payment compared to the sales price to determine your loan to value ratio. So, if you purchase a home for $200,000 and put $20,000 down, your loan to value ratio is 90%.
This doesn’t mean that lenders are unwilling to write loans when you put down less than 20%. They just charge you more for the privilege
Who Needs Private Mortgage Insurance?
Generally, if your LTV ratio is less than 80%, you’re in the clear. If you have poor credit, however, or are otherwise considered a high risk to the lender, you may be required to carry PMI even if you have a 70%, 60%, or even 50% loan to value ratio.
You may be considered “high-risk” if you’ve sold multiple homes recently, have been foreclosed upon, or if you have an unsteady or undocumented income. This should be clearly laid out in your loan documents, and if you aren’t sure how it works, get a clear answer from your loan officer before signing.
How to Avoid Paying Private Mortgage Insurance
If you’re purchasing a new home, but won’t have a significant down payment, ask your loan officer for suggestions on avoiding PMI.
In the past, a popular option was the 80-10-10 or “piggyback” mortgage, which used a combination of a second mortgage or home equity loan and your down payment to reduce the loan to value ratio of the primary mortgage. This may still be available through some lenders today.
Now the borrower is committed on two loans, but since the funds from the second loan are used to pay the 20% deposit, the borrower can avoid the PMI payment. The borrower can typically deduct the interest on both loans on their federal tax return if they’re itemizing deductions, which most homeowners do anyway.
If you look at your monthly mortgage statement and see a line for “PMI,” you’re paying for private mortgage insurance. It probably costs you between $50 and $200 per month, depending on the balance of your loan and your PMI rate.
If you’re already in a mortgage that has PMI, you have two options to remove it:
1. Meet the Loan to Value Ratio
If your loan is near the 80% threshold or whatever threshold your lender stipulated in the initial mortgage paperwork, PMI will be automatically removed by the lender. In practice, most lenders wait until 78%, but if you call and ask, they will remove it sooner.
Since your lender will calculate LTV off the original purchase price, you’ll need to keep track of your home’s current market value. In other words, if your home has increased in value, you can obtain a professional appraisal and present this to the lender as proof that the value has increased.
While professional appraisals usually cost a few hundred dollars, this can be money well spent if it gets you out of paying PMI several months or years earlier than you otherwise would have.
2. Refinance the Mortgage
Before you refinance a mortgage, weigh the expense against the monthly savings. In other words, if you have 25 years left on your current loan, request lender quotes for a 25-year mortgage on your current loan balance amount and see how the numbers add up.
If your current loan requires PMI and a new one wouldn’t, and if you also qualify for a lower interest rate, a refinance will probably make sense. For example, let’s say your current loan requires a loan to value ratio of 70% before you can stop paying PMI and your current loan to value ratio is 75%.
If your credit has improved since you applied for the original mortgage, you may be able to refinance into a new mortgage where the threshold for PMI is 80%. This means you wouldn’t have to pay PMI with the new mortgage.
But to determine if this refinance actually saves you money, look at how long it takes to recoup your closing costs via your monthly savings, and make sure you’ll be in the house that long. Make sure you’re comparing apples to apples when reviewing lender quotes: the new loan term and balance need to be the same as what’s on your current mortgage.