Conventional wisdom states that when buying a house, the responsible thing to do is to make a good down payment. Not only will you keep your mortgage payments lower, but you also will avoid dreaded…
Conventional wisdom states that when buying a house, the responsible thing to do is to make a good down payment. Not only will you keep your mortgage payments lower, but you also will avoid dreaded private mortgage insurance, which often applies to conventional mortgages when down payments are less than 20 percent.
Unfortunately, attempting to save up a 20 percent down payment as home values rise can be like chasing a moving target. PMI can lower that barrier to entry for prospective borrowers, allowing them to become homeowners and begin building equity sooner. That can be especially important when mortgage interest rates are still relatively low. In fact, an analysis of home values from The Mortgage Reports shows that consumers could be missing out on as much as $13,000 per year by putting off a home purchase until they can avoid PMI.
Of course, that doesn’t mean PMI is worth it in every case. After all, it’s an added cost that doesn’t contribute to the equity in your home. Here’s how PMI works and how to remove it when you no longer need it.
Private mortgage insurance is a type of insurance mortgage lenders require on conventional loans when the borrower’s down payment isn’t large enough, usually 20 percent. PMI could also be required if you refinance your mortgage with less than 20 percent equity built up. The government also charges mortgage insurance on certain types of government-backed loans.
The reason lenders charge PMI when the down payment isn’t big enough is to protect their investment in case a borrower can’t make payments. “PMI is a type of mortgage insurance policy that provides compensation by the insurance company to the lender, in the event a borrower defaults on the mortgage,” says Laura M. Endres, an attorney focused on real estate law with Taylor, Eldridge & Endres in Smithtown, New York. “PMI does not protect the borrower from having to pay the mortgage if they are unable to do so. It is an insurance policy only for the lender and has no benefit to the borrower, other than to allow a borrower who would not normally qualify for a mortgage to be approved for a mortgage.”
In other words, the lower the down payment, the riskier the loan; the borrower has to take on a larger loan to cover the value of the home, resulting in a higher payment. And with little equity built up in the property, the lender can end up taking a loss if it turns out that the borrower can’t afford the loan.
Third-party private mortgage insurance companies generally provide PMI policies, and the lender arranges and tacks them onto the mortgage payment. You continue to pay PMI until you’ve built up enough equity in your home. Typically, lenders require a loan-to-value ratio (the total amount borrowed divided by the value of the property) of 80 percent before PMI can be removed.
Say you purchased a home for $200,000. However, you only put down 10 percent, or $20,000. That means your LTV would be 90 percent, requiring you to pay PMI. Until you’ve made enough mortgage payments so that your balance reaches $160,000 — or your home is reappraised at a higher value — you will have to pay PMI.
If you take out a mortgage through certain government programs, the rules on mortgage insurance differ.
The Federal Housing Administration, for instance, provides mortgage insurance on loans made by FHA-approved lenders. In fact, FHA mortgage borrowers can put down as little as 3.5 percent, depending on their credit score. However, FHA mortgage insurance is required for all FHA loans, regardless of down payment size or credit score.
It comes in the form of both an upfront charge that’s paid along with other closing costs or rolled into the total loan amount, as well as a monthly fee that’s included in your payments. Usually, the only way to get rid of the mortgage insurance premium on an FHA loan is to refinance the loan with a non-FHA lender, according to Shawn Sidhu, branch manager and mortgage consultant with C2 Financial Corp. of California.
U.S. Department of Agriculture home loans require no down payment, though mortgage insurance is also required as both an upfront fee and a monthly payment. And like FHA loans, you can roll the upfront portion into your mortgage instead of paying it at closing, but doing that increases the size of your loan and, therefore, the monthly payment and total interest paid.
U.S. Department of Veterans Affairs loans don’t require a monthly mortgage insurance premium, but they do typically require an upfront VA funding fee that varies depending on your type of military service, down payment amount and other factors. Like other government-backed loans, you may roll that fee into your mortgage or pay it at closing. “There are instances where a veteran may be exempt from the VA funding fee, typically due to a service-related disability,” Endres says.
The Consumer Financial Protection Bureau warns that some lenders will offer an alternative to paying PMI in the form of what’s called a piggyback second mortgage. This option — to enable the borrower to reach a 20 percent down payment — is often presented as more cost-effective, but that’s not always the case. Piggyback second mortgages typically have an adjustable interest rate that may be higher than the original loan.
On conventional mortgage loans, PMI generally ranges from 0.3 to 1.5 percent of the original loan amount each year, depending on your credit score and down payment. On a $200,000 mortgage, a 1 percent PMI fee would cost you $2,000 per year, or $167 per month.
PMI is an added cost that makes your mortgage more expensive, so you want to get rid of PMI payments as soon as possible.
To cancel PMI on a conventional mortgage, you usually must meet several requirements, in addition to an 80 percent LTV. Federal law outlines your rights for removing PMI under certain circumstances, but some lenders may have more lenient standards.
Your request to the lender must be made in writing. You must also be current on your mortgage payments and have a good payment history. The lender will need you to prove that there aren’t any other outstanding debts on your home, such as a second mortgage or lien. And the lender might require a home appraisal to ensure that the house hasn’t decreased below the original value. If it has, you might not have enough equity to cancel PMI.
Sidhu says you could request to cancel PMI if your property has appreciated significantly. In this case, you might not have made many mortgage payments, but the LTV still decreased to an acceptable level, thanks to the increased equity in the home.
Unfortunately, PMI is notoriously difficult to cancel. If an appraisal is involved, that process can take months. The good news is that once you reach an LTV of 78 percent (or 22 percent equity in your home’s value at the time of purchase), your lender is required to automatically cancel PMI, even if you don’t formally request it. However, you should verify that the PMI has, in fact, been canceled as soon as you become eligible.
Although mortgage insurance premiums are required for the entire term of FHA loans in many cases, Endres points out that there are a couple of instances in which you can get it canceled. If you took out your mortgage between Dec. 31, 2000, and June 3, 2013, and the LTV is 78 percent or less, you can contact the lender and request to have the mortgage insurance removed. If you took out the mortgage after June 3, 2013, and put more than 10 percent down, the PMI can be removed after 11 years.
“Cessation of PMI is dependent on other factors, such as a good payment history,” Endres says. She encourages borrowers to understand their rights regarding what date they may ask for the PMI to be terminated and to make sure it’s on their calendars.