What is private mortgage insurance (PMI) and when it can be removed
When a bank hands over financing for a home purchase, they take on a great amount of risk. Buyers with a strong credit background and the ability to make a sizable down payment might be ideal mortgage candidates, but many borrowers don’t fit that mold.
Mortgage borrowers that fall into this category can still make their homeownership dreams come true, thanks to private mortgage insurance.
What is private mortgage insurance?
Depending on what type of mortgage loan you choose, an application that falls short of a lender’s typical approval standards might come back with a requirement for private mortgage insurance.
Clearing certain homebuying thresholds, such as a 20% down payment, can be difficult for some borrowers to achieve. Luckily, private mortgage insurance allows these borrowers to secure a home loan with an added cost.
Private mortgage insurance, or PMI, ensures that if a mortgage’s repayment plan falls through, the lending organization will be able to recoup any losses they encountered through the failed loan.
By providing lenders with a promise of reimbursement, PMI lets lenders issue loans that would otherwise be too risky for approval.
In most cases, private mortgage insurance becomes a requirement when a borrower is unable to make a down payment of 20% or more than the home’s selling price, which is not always a negative. Private mortgage insurance provides borrowers with greater purchasing power by making it possible to buy a home with less than 20%.
This benefits first time homebuyers by allowing them to reach their savings goals much faster and buy a home sooner than would be otherwise possible. This also helps expand home buying options by lowering the sales price ceiling for these prospective buyers. Thanks to PMI, these buyers can consider more home options, helping them find the very best fit.
By putting less money down, borrowers also benefit from keeping that cash on hand for other expenses. Paying off other debts, making investments or improvements to the home can help can be possible thanks to PMI lowering down payment requirements. These additional investments can also help offset the cost of PMI down the line.
How much is private mortgage insurance?
The cost of your PMI policy will be relative to current insurance rates and your own financial situation. According to Investopedia, a private mortgage insurance policy will cost about 0.5% - 1% of your loan amount each year.
If you were to take out a mortgage for $200,000, you could expect to pay around $1,000 to $2,000 per year in PMI premiums. These expenses are broken down and included in your monthly mortgage payment, meaning you could be paying roughly $85-$170 for PMI each month.
Before deciding to move forward with a home purchase, be sure to closely review the associated costs to find an affordable mortgage structure.
To determine exactly how much PMI coverage will be required, your lender will take other details from your mortgage process into account.
Let’s take a closer look at which factors will influence your lender’s decision to require a PMI policy:
- Down payment amount
- Credit report & credit history
- Type of loan
Down payment amount
One of the most important factors in your lender’s PMI determination will be the amount you pay for the property’s down payment.
If you’re unable to commit more than 20% of the home’s sales price towards a down payment, your lender might consider you a risky borrower. Luckily, this doesn’t mean you won't be able to secure financing. Paying for private mortgage insurance can help ease your lender’s concerns about the possibility of foreclosure and reduce the negative impact of a lower down payment, leading to your mortgage’s approval.
If you’re only able to contribute less than 20% towards a down payment, PMI might be the solution you’re looking for. However, always be mindful that monthly premiums will be included in each of your mortgage payments, increasing the overall amount paid throughout the duration of your loan.
Credit report & credit history
Before a mortgage gets your lender’s stamp of approval, they’ll need to conduct a background check on your credit history. This information, provided on your credit report outlines any of your closed or ongoing loans, history of managing debt and previous loan applications.
If your finances have been steady and well-managed in recent years, meaning you’ve avoided maxing out credit cards and haven’t borrowed loans you can’t pay back, your ability to borrow money will be much better. This advantage is reflected in your credit score, a number that signifies your financial history and ability to manage debt.
Here’s a look at typical credit score ranges and how they’ll be perceived by mortgage lenders:
- <580 = Poor
- 580-669 = Fair
- 670-739 = Good
- 740-799 = Very good
- 800-850 = Exceptional
If applying for a conventional loan, you might have trouble securing approval if your score falls below 620. However, if you apply for a mortgage with a low credit score and it is approved, your lender might attach a PMI requirement to protect themselves against the perceived risk of lending you money, if your down payment is less than 20%
A low credit score can reflect a history of poor debt management. By requiring you to pay a little extra each month, your lender can ensure their money is protected if the loan ever falls through.
Type of loan
The type of mortgage you decide to apply for will also influence how much you can expect to pay in private mortgage insurance. Some loan structures are inherently riskier than others, so you should expect your lender to adjust their PMI requirements accordingly.
Fixed rate mortgages
Fixed rate mortgages typically present less risk because the borrower pays a fixed amount each month throughout the term of the loan. The consistency of these loans, such as a 30-year fixed rate mortgage, provide borrowers with clear expectations around how much they’ll need to pay each month. Given this relatively lower risk, premiums for private mortgage insurance on fixed-rate mortgages tend to be lower.
Adjustable rate mortgages
The amount to be paid on an adjustable rate mortgage, on the other hand, is not as cut and dry. Since the interest rate on ARMs can fluctuate with the market, the homeowner might have a more difficult time anticipating how much will be needed for mortgage payments each month. This uncertainty increases the lending risk associated with adjustable rate mortgages, which could result in your lender attaching a pricier PMI requirement.
How long do you have to pay private mortgage insurance?
In order to remove private mortgage insurance from your monthly payments, you’ll need to gain some equity in the home. Homeowners who bring down their mortgage’s principal balance to 80% of the original appraised value can contact their lender and request their PMI to be eliminated. By gaining at least 20% equity in the property, you’ll have an ownership stake that is equal to the amount lacking in your initial down payment.
If you’re looking to cancel your private mortgage insurance payments sooner, there are a few ways to reach the 20% equity threshold sooner:
Scheduling a new appraisal for your property could lead to a shift in your equity balance. If the new estimate comes back lower than the first, it changes the amount of equity you’d have gained up until that point. However, your lender will decide whether to honor the new appraised value or stick with the initial value estimate.
Higher loan payments
Paying a little more than your monthly minimum is another alternative to building equity in a home at a faster rate.
Adding an extra $50-$100 a month to your scheduled payments can go a long way towards paying off interest and bringing down the loan’s balance over time. This can help you shed your PMI requirement sooner than if you paid the minimum amount each month.
How can I avoid private mortgage insurance?
The easiest way to avoid paying for private mortgage insurance would be to make a more substantial commitment to the home upfront. Though it is a large sum of money to pay all at once, a sizable down payment could end up saving you thousands in the long run.
If a 20% down payment isn't an immediate option, your best bet might be paying for PMI in smaller installments.
Private mortgage insurance is the lender’s way of insuring against a loan that they view as risky. While this coverage does protect the lender, it has to be paid for by the borrower.
For a policy that can help protect you and your assets, consider homeowners insurance.