When considering a new home, many borrowers expect to pay for homeowners’ insurance to protect their investment should any problems arise. In much the same way, lenders turn to private mortgage insurance, or PMI, to protect them if a borrower is unable to make their mortgage payment.
How does mortgage insurance work, and how is private mortgage insurance calculated?
Key takeaways
- Private mortgage insurance (PMI) protects lenders when borrowers can’t make mortgage payments.
- PMI rates vary from 0.5 to 2.25% of the loan amount per year and are determined by factors such as down payment, loan size, mortgage type, and credit score.
- PMI can be paid upfront or added to monthly mortgage payments and is eliminated when certain conditions are met, such as achieving a 78% loan-to-value ratio or halfway through the loan term.
- PMI provides a way for borrowers to become homeowners who wouldn’t otherwise qualify, and it’s tax-deductible.
What is Private Mortgage Insurance (PMI)
Private mortgage insurance, also known as PMI, is an insurance policy that many conventional home lenders require to help ensure that they are protected if the borrowers cannot make their mortgage payments. This insurance helps ensure the lenders that they can recover some of their investment in the event of default. But it is also beneficial for the borrower as, in most cases, this lender protection often allows borrowers to become homeowners when they are otherwise considered a risk.
How does mortgage insurance work?
Mortgage insurance works by lowering the risk to the lender when making a home loan. In many cases, the addition of PMI to a mortgage allows borrowers to qualify for a loan when they might not otherwise be able to. In most cases, borrowers with less than a 20 percent down payment are required to have PMI for a conventional loan. Most FHA and USDA loans require PMI as well.
How much does PMI cost?
The cost of PMI varies by loan program and several different factors that we will discuss below. On average, the cost of PMI is about 0.5 to 2.25 percent of the loan amount each year you have the loan. Your PMI can be paid upfront or added to your monthly mortgage payment.
How is Private Mortgage Insurance calculated?
As mentioned above, mortgage insurance is calculated as a percentage of your mortgage loan amount. For example, if your original loan is for $250,000 and you have a PMI rate of 1%, your mortgage insurance would be $2,500 for the year. This amount can be paid upfront or broken down and added to your monthly mortgage payment.
Annual mortgage insurance is re-calculated every year based on your loan balance. As you pay off the loan, your PMI costs go down.
Factors that determine mortgage insurance rate
With PMI rates ranging between 0.5 and 2.25 percent, how do you know your PMI rate? The PMI rate that you receive depends on a variety of different factors.
Loan size
The biggest determining factor for your PMI rate is the size of your home loan. As you might expect, the higher your loan is, the higher your PMI is likely to be. This is because the lender takes a bigger risk on a higher loan value.
Down payment
In general, PMI is required for any loan with a down payment of less than 20%. However, your PMI rate is also dependent on just how much you put down. While many loans offer as low as 3%, the smaller down payment will result in a higher PMI rate. Even if you are still under the 20% down payment threshold, the higher your down payment amount, the lower your PMI rate.
Mortgage type
The type of mortgage you choose can make a difference in your PMI rate. Adjustable-rate mortgages tend to have a higher PMI than fixed-rate mortgages. This is because interest rates can rise, meaning your monthly payments can increase.
Credit score
Your credit score can make a big difference in your PMI rate, as with anything loan-related. The higher your credit score, the more creditworthy you appear to the lender, thus showing less risk. While a conventional loan typically requires a credit score of 620, for other loans, such as FHA, a credit score can go as low as a 500. You can expect to pay a higher PMI percentage with scores this low.
Frequently asked questions
When it comes to home mortgages and PMI, borrowers often have numerous questions. Here we offer answers to some of the most common PMI questions.
1. Do you need PMI?
This depends. In general, a lender will require PMI if your down payment is less than 20% of the total loan amount. However, PMI is not required for the entire length of your mortgage. Once you reach a 78% loan to value ratio (LTV), the lender should automatically remove your PMI. In addition, your PMI is removed when you reach the halfway point of your loan term. For example, with a 30-year mortgage, the PMI is removed at the 15-year mark even if you do not reach the 78% LTV.
2. Is PMI required?
In general, PMI is required on any conventional home loan with less than 20% down payment. However, there are exceptions. In some cases, lenders offer a PMI-free conventional loan but will instead bump up your interest rate for the life of the loan.
3. Is mortgage insurance a bad thing?
While the additional cost of PMI may seem like a bad thing on the surface, the truth is PMI often gives borrowers a path to homeownership that would not otherwise be available. Without PMI, borrowers would be required to wait until they had the available 20% down payment, making homeownership difficult. In addition, PMI is not required for the life of the loan and is eventually removed once you meet the criteria.
4. Is mortgage insurance tax-deductible?
Yes! Just like any other form of mortgage insurance, PMI can be deducted when you file your income tax return each year.
PMI offers a quicker path to homeownership
While the idea of an added cost to your mortgage payment is never appealing, PMI enables many borrowers to purchase a home without a large down payment. It protects the lenders from potential risk and makes you, as a borrower, more appealing to the lender, enabling you to achieve homeownership sooner.
At Hero Home Programs, we understand how confusing all these terms can be when purchasing your first home. Our goal is to help everyone achieve homeownership with the best rates possible. To learn more about how we can help, schedule a call with us today.
