When applying for a mortgage, the lender in question usually requires a down payment of 20% of the home’s total price. When the borrower can’t afford that amount, lenders tend to look at the loan as a ‘risky’ investment and require that the buyer take out PMI, or private mortgage insurance. PMI serves as an added layer of protection for the lender if the borrower should happen to default on their mortgage, sending the home into foreclosure.
How does PMI work, exactly?
PMI is often included as part of the borrower’s monthly mortgage payment to the lender, although it can sometimes be paid at closing as a one-time lump sum. Before you give up your home buying dreams altogether, know that PMI isn’t permanent. As long as the borrower stays up-to-date with their payments, the lender is obligated to end PMI on the date the loan’s balance reaches 78% of the home’s original value—when the equivalent of a 22% down payment has been paid. It’s also worth noting, however, that borrowers who have paid the equivalent of a 20% down payment can contact their lender and request that their PMI payments be stopped.
How much does PMI cost?
PMI will cost between 0.5% and 1% of the total mortgage amount annually. This can be a hefty extra cost for many—one they’d love to be rid of. A borrower with a 1% PMI fee on a $200,000 loan, for instance, would end up paying an additional annual cost of about $2000, or $166 monthly, on top of the cost of their mortgage payments. There’s no denying that if you can avoid paying PMI, you should.
Ways to avoid paying PMI
The easiest way to avoid PMI is to search for a different home on which you can afford to put 20% down. But if you’ve fallen in love with a particular home and don’t have the funds for a 20% down payment, it’s still possible to avoid PMI by taking out a smaller loan—although usually at a higher interest rate—to cover the amount of the down payment. This, of course, is in addition to the mortgage loan, so you’d be left with two loans to pay down. This practice is commonly known as a piggyback mortgage. Although you’re committing on two loans, PMI is not required, as you’re using the second loan to pay the 20% deposit. If you decide to go this route, you may be able to deduct the interest on both loans on your federal tax returns.
Bottom line: PMI can be an expensive headache, but depending on your case, it may also be a necessity. Especially for first-time buyers who might not have enough money saved to cover a 20% down payment, PMI is a simply a necessary consideration. For buyers eager to own a home without waiting until they’ve amassed more funds, paying mortgage insurance could very well be worth it in the long term.