What Is Private Mortgage Insurance?
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- Private mortgage insurance (PMI) is a supplemental insurance policy required for some mortgages with a down payment lower than 20%.
- You’ll typically pay between 0.5% and 1% of your original loan amount for PMI each year until you build up at least 20% equity in your home.
- It’s important to note that PMI provides additional protection for the lender, not the borrower. If you find yourself falling behind on your loan payments, PMI will not reduce the risk of foreclosure.
Mortgages come with a certain amount of risk for borrowers and lenders alike. Falling behind on mortgage payments can put a homeowner in danger of foreclosure and means that the lender may not recover the initial investment they made in the homebuyer.
Private mortgage insurance (PMI) is one way that lenders attempt to reduce some of their risk. But how does PMI work? And does it affect every homebuyer? Learn more about the types of PMI and when to expect it in the homebuying process.
How does PMI work?
PMI is a supplemental insurance policy required for some mortgages with a down payment lower than 20%. Mortgage loans with a low down payment have a high loan-to-value (LTV) ratio, meaning the amount of your mortgage is high compared to the assessed value of the property. Loans with a high LTV ratio may be riskier investments for lenders because the homebuyer is starting out with a smaller amount of equity in the home.
That’s where PMI comes in. Typically, PMI premiums are paid to a lender, usually on top of your monthly mortgage payment, to offset this risk. The cost of your PMI and the way that you pay your lender will depend on the unique terms of your loan. Lenders generally require PMI payments until you have built up at least 20% equity in your home.
It may seem like an obvious choice to simply offer a larger down payment and avoid PMI altogether. However, that’s not a possibility for every buyer. PMI can be a stepping-stone to help lower-income buyers, especially first-timers, achieve their dream of homeownership. In some cases, PMI can also help higher-risk buyers obtain conventional loans from private lenders that they might not be approved for otherwise.
- How much does PMI cost? You’ll typically pay between 0.5% and 1% of your original loan amount for PMI each year. You’ll probably be required to pay more if you have a large loan, a smaller down payment or a low credit score, as these factors can make your loan riskier to the lender. PMI may also be more expensive if you have an adjustable-rate mortgage (ARM) — a loan with an interest rate that fluctuates based on current market conditions.
- How do you calculate PMI? Wondering how to calculate PMI? First, ask your lender about your PMI percentage and then multiply the total amount of the loan by this percentage to estimate your premium. If you’re paying up front, this is the total estimated cost of your PMI. If you’re planning to pay over time, divide this figure by 12 to get a close approximation of your monthly PMI premium.
What are the types of PMI?
There are several different forms of PMI, which differ depending on who pays the insurance premium and how often the premium is paid.
- Borrower-paid mortgage insurance (BPMI). This is the most common type of mortgage insurance. You, the borrower, must pay a premium every month until you reach 20% equity in your property — meaning the fair market value of your home minus the amount you owe on your mortgage totals at least 20% of your home’s value.
- Single-premium mortgage insurance (SPMI). With this kind of PMI, the premium is either paid in full when you close on your loan or financed into your mortgage. In this PMI model, your payments will likely be lower than with BPMI, but no portion of the total premium is refundable if you refinance or sell before you meet the 20% equity requirement.
- Split premium mortgage insurance. For this type of PMI, you’ll pay a portion of the premium when you close the loan (much like SPMI) and the remainder in the form of a monthly premium (similar to BPMI). With split-premium mortgage insurance, you can reduce both the amount of cash you’ll need up front and the amount of your monthly payments.
- Lender-paid mortgage insurance (LPMI). With this type of PMI, the borrower doesn’t pay anything up front or monthly. Instead, the lender covers the costs of the mortgage insurance. The downside is that lenders often incorporate LPMI into the cost of the loan itself, so you may end up paying for it anyway in the form of a higher interest rate or fees.
5 ways to avoid or reduce PMI
PMI may be a necessary – if inconvenient – cost of homeownership. But some borrowers may be able to reduce the amount of PMI owed or avoid it altogether.
- Make a larger down payment. Begin saving for a down payment long before you apply for a loan. If you can put down at least 20% of the property value, you won’t have to pay for PMI at all. Even if you can’t meet the 20% threshold, getting closer to that number will decrease your PMI premium and save you money over time. And the best part is this strategy will also decrease the total amount of your loan, saving you money in interest.
- Pay more on your mortgage. If you want to cancel your PMI early, you’ll need to meet the 20% equity requirement more quickly. You can do this by making higher or more frequent payments on your mortgage. However, it’s important to monitor your progress and be proactive. When you know you’ve reached the 20% threshold, be sure to reach out to your lender and ask them to cancel your PMI.
- Refinance. If you refinance your mortgage, PMI may no longer be required, depending on the type of loan you secure and the current value of your property. A new mortgage with a lower interest rate might mean you have enough equity to avoid the PMI requirement. However, it’s probably not worth the effort and expense to refinance just to get rid of PMI — make sure you’ll also benefit from a lower interest rate and better loan terms.
- Consider government-backed loans. Loans from some government agencies, such as the Department of Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA), don’t mandate mortgage insurance. They may also offer better interest rates and repayment terms. However, loans from the Federal Housing Administration (FHA) are one notable exception, as they require mortgage insurance regardless of the size of your down payment.
No matter which type of PMI is attached to your loan, it’s important to note that mortgage insurance provides additional protection only for the lender. If you find yourself falling behind on your loan payments, PMI does not provide protection for the borrower and you may still run the risk of foreclosure.