Depending on the type of home loan or refinance option you are looking at, your lender may require private mortgage insurance (PMI). But what exactly is private mortgage insurance, and how much additional cost will it add to your monthly mortgage payments? Are there things you can do to avoid paying PMI? Here we take an in-depth look at PMI and what it means for you when buying or refinancing a new home.
- When you are taking out a loan with a high loan-to-value (LTV) ratio, it poses a higher risk to lenders. PMI is a way to lower that risk and is often required by lenders.
- PMI can be paid as a monthly premium, an upfront premium, or a combination of both. Regular monthly premium payments, where the lender adds the premium amount to your mortgage payment, are the most common.
- PMI costs can vary based on a number of different factors, such as the total loan amount and the borrower’s credit score.
What is PMI?
Unlike other homeowners insurance policies, PMI is an insurance policy that protects the lender in the home-buying process. Lenders often require PMI for mortgages with a high LTV ratio that poses a higher risk of default. Should a default happen, PMI pays the lender part of the remaining mortgage balance, so their loss is reduced. While PMI is designed to benefit the lender, it does provide benefits for the borrower as well. Paying PMI on a high-risk conventional mortgage may actually help you qualify for a mortgage you might not have otherwise been eligible for.
Importance of understanding PMI
When applying for a home mortgage to purchase or refinance a home, it is important that you have a clear understanding of all potential charges and interest rates, as well as your PMI requirements and the method you will be using to pay PMI premiums. This helps give you a clearer picture of your upfront and monthly costs when purchasing a home.
When is PMI required?
Whether you are buying a new home or refinancing an existing home, your lender may require PMI when your equity in the home is less than 20 percent. For example, if you were purchasing a new home with a 10 percent down payment, you would only have 10 percent equity, and it is likely that your lender will require PMI.
Who provides PMI?
If your lender requires PMI for your loan, you do not have to do anything. Your lender will arrange for a PMI policy with the insurance provider of their choice, and, in some cases, you can choose your payment method for your premiums. This is typically a monthly amount that is automatically added to your monthly mortgage payment. In some cases, your lender may offer you the option of an upfront premium, where the full cost is paid at the same time as other closing costs and does not affect your monthly mortgage payment, or a combination of both, where you pay a premium amount at closing, as well as a lower monthly premium added to your monthly mortgage payment.
How is PMI calculated?
Lenders calculate PMI as a percentage of your mortgage loan amount. In general, PMI rates are typically 0.1%-2% of your total loan value and will vary by lender. To estimate your mortgage insurance, follow these steps:
Determine property value/home value. This can come from a recent appraisal in the event of refinancing or from the amount being offered to purchase the home.
- Determine your loan amount. In the case of a new home purchase, subtract your down payment amount from the property value or purchase price. If you are refinancing, the value of your loan will be your remaining mortgage balance.
- Find your loan-to-value ratio (LTV). Divide the loan amount by the total property value. If your percentage is 80% or lower, you are not required to pay PMI. If, however, it is higher, continue to the next step.
- Obtain the lender’s PMI percentage. Ask your lender to provide the PMI percentage they intend on using or the range they may use.
- Estimate your annual PMI premium. Multiply the total loan amount by the percentage given to you by your lender. This will be your annual PMI premium. If you are making monthly payments, divide this number by 12 to determine how much it will raise your monthly mortgage payments.
Terms you should know
When determining your PMI, there are some key terms that are important to understand. These include:
- Home price: This is the price you intend to pay for the home. If you want an estimate of your PMI payments while you are home shopping, use the loan amount you have already been pre-qualified for.
- Interest rate: The interest rate is the cost a borrower pays to the lender expressed as a percentage rate of the total loan amount.
- Down payment: This refers to the amount you plan to pay the lender at closing to purchase the home. The more you pay, the higher the equity amount you have in the home. If you put down at least 20%, you are not required to have PMI in place.
- Loan term: This is the amount of time it will take to completely pay off your mortgage with your current interest rate and payment schedule. This also includes whether or not you have a fixed or adjustable-rate mortgage.
- Credit score: A credit score is a number that reflects a prediction on how likely you are to repay your debts based on your past and current payment history. The higher your credit score, the less likely a risk you are to lenders.
Factors that determine PMI rates
The percentage amount that a lender uses to determine your PMI will depend on a number of different factors, such as the ones mentioned above. As you can assume, the higher your home price, the higher your PMI premiums will be. Larger loans require the lender to take a larger risk, leading to higher PMI rates.
As we mentioned, down payments over 20% often mean PMI is not required. That being said, the more you have for a down payment, the lower your PMI rate will be. When it comes to PMI rates, adjustable-rate mortgages tend to be higher. The higher your credit score, the more influence it has on dropping your PMI rate. If your debt-to-income ratio (DTI) is above the normal threshold, typically around 45%, then you are likely to have a significantly higher PMI rate.
Not every lender or loan type is the same
In addition to the terms above, keep in mind that every mortgage lender is different. PMI rates and providers are not uniform, and one lender’s PMI rates may be substantially higher than another visa versa.
How much is PMI?
Generally, the PMI rate can be anywhere from 0.1%-2% and vary based on provider and lender. Once you determine your loan value and multiply it by the PMI rate percentage that your lender provides, you will get a clear picture of what your PMI will cost. For example, if you purchased a $350,000 home and put down 10%, or $35,000, with an estimated 0.58 PMI rate, your monthly PMI would be $152 per month for 7.5 years before you would have 20% equity in the home and no longer required to pay PMI.
How to reduce or avoid PMI
In general, PMI is required for any conventional loan where you provide less than a 20% down payment on a new home or have less than 20% home equity for a refinance. If you want to avoid paying PMI completely, the best plan of action is to make a down payment of more than 20%. If that is not feasible, which is common for most first-time home buyers, consider paying more than your monthly mortgage amount in order to pay down your loan balance faster and reach 20% equity sooner, reducing your total PMI amount.
Another option is to explore a VA loan backed by the U.S. Department of Veterans Affairs or an FHA loan backed by the Federal Housing Administration that offers down payment assistance, helping you to make that 20% down payment requirement that eliminates PMI.
When it comes to PMI rates, many factors, such as total loan value and borrower’s credit score, can affect your perceived risk to the lender. Higher credit scores, for example, help reduce your risk to the lender, thus resulting in a lower PMI percentage rate.
Purchasing a home with PMI
If you are looking to purchase a new home with less than 20% down or refinance a home with less than 20% equity in, you will likely be required to pay private mortgage insurance or PMI. As a borrower, there are things that you can do to help reduce your PMI rate and, in some cases, even avoid paying PMI with the help of down payment assistance programs.
Helping you navigate the home-buying process
Buying a new home or refinancing your current home can often be overwhelming, especially with terms like PMI and LTV. At Hero Home Programs, it is our job to understand the lingo, help you navigate the home-buying process, and secure a mortgage for the home of your dreams. Schedule a consultation today to learn more about how we can help navigate PMI.