If you are not able to put up a 20% down payment on your home purchase, you must pay for insurance. They call this kind of insurance as a Private Mortgage Insurance or PMI. This is how the lending bank will protect itself in the event that you, as a borrower, were to default on your loan.
So you can see, the insurance does not actually protect you but you are the one who is supposed to pay for it. The amount you must pay will be a percentage of the monthly amount you will pay for your house. It will vary from borrower to borrower depending on the amount of loan and their credit score.
Banks have learned their lesson during the housing crisis so they do not want to give risky loans. If you fall into the type of borrower who may be at risk for default, they will require a PMI.
What is Mortgage Insurance?
If you’re buying a home and can’t pay at least 20% as a down payment, you might have heard of PMI already. Maybe, you still don’t know what a PMI is and why you still have to get one.
Like any other insurance product, mortgage insurance is protection against a possible loss. As its name suggests, it specifically provides insurance against a loss related to a mortgage.
Mortgage insurance comes in two basic kinds with nearly similar initials:
- Private Mortgage Insurance, also known as PMI.
- Mortgage Insurance Premium, also known as MIP.
As a policy, Fannie Mae and Freddie Mac require that loans with less than 20% down at closing must carry mortgage insurance. As a rule, the lower the down payment to home, the higher the PMI payment.
Let’s take the case of the Conventional 97 Program as an example. Although it allows for just a 3% down payment, it requires a larger PMI policy than a loan with a 10% down. Although technically, the PMI is an annual fee, they spread it out into 12 installments. This means that the borrower pays this to the lender on top of his monthly amortization.
On the other hand, the other insurance type, MPI, is for loans made through the Federal Housing Administration (FHA). Insurance is mandatory for FHA loans regardless of the amount of down payment. However, the FHA MIP amount depends on the down payment and length of the loan.
What does PMI do?
PMI serves as a protection for banks that lend money to borrowers. It will help the bank recover in case their borrowers default from their loans and go into foreclosure. It does not protect the borrower in any way. Should the borrower stop making payments on his loan, he will lose his home.
PMI is not homeowner’s insurance and will not protect your home or belongings if fire or natural causes destroys your property. It only protects the bank in case of borrower default.
How To Avoid Paying Mortgage Insurance?
For buyers who are adamant about paying for mortgage insurance, here’s what you can do:
1. Make a 20% Down Payment
Conventional lenders waive the insurance for loans with 20% or higher down payment. So, the surest way to not pay for insurance is to go big on the down payment. The money for down payment can come from the borrower’s own pockets or gifts from family members. So long as a borrower can put in at least 20% down, the PMI is out of the picture (See How To Find The Best Mortgage Lender?).
There is another option if a borrower doesn’t have the 20% down payment. It’s called the 80/10/10 mortgage.
It’s also called a ‘piggyback’ loan, where lenders will require the borrower to pay 10 percent down at closing. Simultaneously, the borrower will use a second mortgage for the other 10 percent.
With the piggyback loan, borrowers will technically be paying less than 20 percent but without the need to pay for PMI.
2. Reach 20% Home Equity
For conventional loans, mortgage insurance is not permanent. Lenders will require it only until the borrower’s home equity reaches 20% of the home’s market value.
In due time, because borrowers are also paying off part of the principal, they’ll like reach that level. When that happens, they can already petition the lender to waive the PMI requirement.
During times when home prices are rising, this may happen faster. A borrower can also accelerate the process by making extra principal payments every month.
Under the Homeowner’s Protection Act of 1998, lenders are required to alert borrowers when they are eligible to stop paying for mortgage insurance. That’s one less item to keep track of.
3. Refinance Your Mortgage Insurance Away
Under the FHA MIP policy, the borrower must pay mortgage insurance for as long as the loan is in effect. If the borrower retires the loan, so does the FHA MIP.
An FHA-backed homeowner can use the FHA MIP cancellation policy to his advantage. All he needs to do is refinance the FHA mortgage insurance right away. And with the current situation in the housing market, it has become much easier.
Home values in the U.S. have risen by more than 30% since late 2012. Consequently, borrowers who have used FHA financing in this decade have already built up some equity. Now, with even just 5% equity (i.e., a 97% LTV loan), they can be eligible to refinance their FHA MIP away by switching to conventional financing.
Borrowers may still have to pay MIP for some time in the early stages of the loan. In a conventional mortgage, when the loan reaches eighty percent loan-to-value, the MI payment goes away.
4. Use The VA Home Loan Guaranty Program
The VA Home Loan Guaranty program allows for 100% financing and does not require mortgage insurance. So if you are an eligible VA borrower, check out your VA entitlements first. After all, the G.I. Bill guarantees all these benefits and you should maximize all of its advantages.
Veterans and army personnel can use a VA loan to buy, build or improve upon any primary residence without the need for a down payment. VA mortgage rates usually beat conventional and FHA rates, making it the most affordable loans available today. Borrowers should consider the low rates and the no down payment options.
Any VA-approved lender would be able to provide quotes on the mortgage rate as well as other information about the mortgage.
Does PMI protect me if I can’t make payments
Let’s get something straight. Many homeowners mistakenly think that the PMI is a homeowner’s insurance and will protect them if they can no longer make payment. The PMI is a banker’s insurance and NOT a homeowner’s insurance. If the borrower stops making payment, he can lose his home – let’s be clear about that.
As long as the borrower has a mortgage on the house, he should have homeowner’s insurance (which is different from PMI). The bank requires it and it is a good investment for a homeowner even if he has paid off the mortgage.
Alternatives to PMI
Many borrowers who put up a low down payment often ask if there are alternatives to PMI. This is different from knowing how to avoid PMI. Alternatives are available but often have the same cost. They just have different names and insurers market them differently.
Some lenders will offer jumbo loans with less than 20% down payment and no mortgage insurance. It attracts borrowers because of its no mortgage insurance feature. However, if one were to look at the fees, you will see that you are not necessarily saving money on the deal. This is because a borrower will have to pay a higher rate on the loan – closely equivalent to Lender-Paid PMI on a conforming loan.
Technically, it’s an alternative to PMI but the borrower does not avoid the fees. Lenders spell it out in marketing of a conforming loan with Lender-Paid PMI but are less clear with jumbo loans with less than 20% down. Most of these loans carry tags with phrases like “No mortgage insurance.”
Can I Cancel PMI?
Homeowners should know that they could cancel the PMI once they’ve paid their loan. This would mean that they would own just eighty percent of their homes.
Realistically, it may take longer than they expect because during the early part of the loan, most of the payments cover the interest. Very little portion of the payments actually goes to reduce the principal. Many lenders will allow borrowers to cancel the PMI after 2 years of timely payment (See The Most Important Questions You Should Ask Your Mortgage Lender).
Here’s the catch: banks will not automatically cancel the PMI when a borrower reaches the point when the PMI is no longer necessary. So if a borrower thinks he has built enough equity into his home, he should call his bank. He can ask them to review his loan and if eligible, to ask the bank to drop his PMI requirement. Without the PMI, the house payment will become less burdensome in the future.
So if a borrower is purchasing a home without a down payment (like in the case of FHA loan), he should consider the PMI cost when setting a budget. This would protect him from overspending on a house he could not afford in the future.
How to Cancel PMI
For a borrower who has a conventional conforming loan, he can ask his lender to cancel the PMI once he ha reached 22 percent equity on his home. This would mean that he has paid his loan down to 78 percent of the purchase price of the house.
So, if prospectively, a borrower can see that he can accomplish this within a few years, he should get a Borrower-Paid PMI and not a Lender-Paid PMI.
A Lender-Paid PMI means a higher loan rate throughout the life of the loan regardless of how much equity a borrower builds up. The same condition applies for a jumbo loan because the higher rate compensates for the low down and ‘waiver’ of the PMI.
For FHA loans, a borrower will most likely pay for FHA MIP for the entire life of the loan. Here’s a schedule of when lenders can cancel FHA MIPs.