When you apply for a mortgage, the lender may require a down payment of 20% of the home's purchase price. Many mortgages do offer buyers the opportunity to put down a lower amount, but you will have to pay for mortgage insurance.
PMI protects the lender in the event that you default on your primary mortgage and the home goes into foreclosure. When you put down a lower amount,a lender will consider the loan as a riskier investment and require that the homebuyer buy private mortgage insurance (PMI) with a premium that will be included in the monthly mortgage payments.
Key Takeaways
- Lenders require borrowers to pay PMI when they can't come up with a 20% down payment on a home.
- PMI is usually included in the monthly payment.
- PMI can be removed once a borrower pays down enough of the mortgage's principal.
- A homebuyer may be able to avoid PMI by piggybacking a smaller loan to cover the down payment on top of the primary mortgage.
How PMI Works
One of the measures of risk that lenders use in underwriting a mortgage is the loan's loan-to-value (LTV) ratio. LTV is the ration of the amount of the loan to the value of the home. Most mortgages with an LTV ratio greater than 80% require that the borrower have PMI as they are considered more likely to defaulton a loan.
PMI is usually paid monthly as part of the overall mortgage payment to the lender, but sometimes it is paid as a one-time, up-front premium at closing. PMI isn't permanent—it can be dropped once a borrower pays down enough of the mortgage's principal.
Provided a borrower is current on their payments, their lender must terminate PMI on the date the loan balance reaches 78% of the original value of the home (in other words, when the equity reaches 22%). A borrower who has paid enough towards the principal amount of the loan (the equivalent of that 20% down payment) can contact their lender and request that the PMI payment be removed.
PMI discontinuation rules only apply to conventional loans. Other types of mortgages, such as those offered by the Federal Housing Administration (FHA), have their own rules for removing mortgage insurance.
The Cost of PMI
PMI costs can vary, typically between 0.5% and 2.25% of the entire mortgage loan amount annually, depending on factors like the size of the loan and your credit score. PMI costs can raise a mortgage payment significantly. Let's say, for example, that you had a 1% PMI fee on a $200,000 loan. That fee would add approximately $2,000 a year, or $166 each month, to the cost of your mortgage.
This cost may be a good reason to avoid taking out PMI, along with the fact that canceling can be complicated. However, for many people PMI is crucial to buying a home, especially for first-time buyers who may not have saved up the necessary funds to cover a 20% down payment. Paying for this insurance could be worth it in the long run for buyers eager to own their own home.
Since PMI is designed to protect the lender, it will not protect you, the borrower, if you fall behind on your payments and you could still lose your home to foreclosure.
Be aware of mortgage servicers that charge a private mortgage insurance premium when one is not required. The Consumer Financial Protection Bureau (CFPB) found that these types ofjunk fees can occur.
How to Avoid Paying PMI
If a homebuyer doesn't have the funds for a 20% down payment, it's possible to avoid PMI by taking out two loans—a smaller loan (typically at a higher interest rate) to cover the amount of the 20% down, plus the main mortgage. This practice is commonly known as piggybacking.
Although the borrower is committed to two loans, PMI is not required since the funds from the second loan are used to pay the 20% deposit.
Another option to avoid PMI is to reconsider the purchase of a home for which you have insufficient savings to cover a 20% down payment and instead look for one that fits your budget.
Is PMI Automatically Removed at 20%?
For many mortgages, you can request that your PMI be removed after you've paid enough so that you have 20% equity in your home. Lenders will automatically remove PMI when you have a loan-to-value ratio of 78%, or have 22% equity in your home.
How Do You Avoid PMI With 10% Down?
When you put 10% down on a mortgage you will have to pay private mortgage insurance (PMI). However, if you want to avoid paying PMI, you can take out a smaller loan that brings your total down payment to 20%, so you will not have to pay PMI. Essentially, you will have two mortgages. This is called piggyback second mortgage.
How Do I Remove PMI from an FHA Loan?
You cannot remove premium mortgage insurance (PMI) from an FHA loan that is made after June 3, 2013. To remove your PMI from an FHA loan, you will need to pay the loan off fully or refinance to another loan.
The Bottom Line
PMI can be a costly necessity for homebuyers who don't have enough money saved for a 20% down payment. It may be possible to avoid PMI by taking out the main mortgage plus a smaller loan to cover the costs of a 20% down payment. However, for first-time homebuyers, PMI may be worth the extra money for the mortgage.
