What is Private Mortgage Insurance (PMI)? Do I need it?

A first time homebuyer’s journey starts with a lot of questions. One of the most common ones is: “How much money do I need for down payment”? If you are one of those, you sure would benefit a lot by knowing about Private Mortgage Insurance. Or PMI, as it’s popularly known.

If you are someone who doesn’t have a lot of cash saved up to make the standard 20% down payment (that is typically required), PMI helps you buy the dream home without you having to wait.

To understand why and how, let’s first understand how it all works.

What does buying a home using a mortgage entail?

Most people in the US buy homes by paying a fraction of the home purchase price (usually a minimum of 20%).They borrow the remaining funds from a mortgage lender in the form of a conventional loan.

The borrowers make monthly principal and interest payments and pay this loan over time (say over 15 or 30 years).

If the borrower is unable to make the monthly loan payments at any point, the lender can foreclose the property and sell it off to recover the loan amount.

What is the importance of a 20% down payment?

A lender typically requires the borrower to contribute at least 20% to avoid mortgage insurance. By requiring the borrower to pay at least that much, the lender’s main goal is to protect itself from any loss in case of a foreclosure.

And how does the protection work? Say, a foreclosure happens and the property price has dropped since the purchase. In that case, the lender runs the risk of recovering less than the loan amount.

But as long as the property price drop is less than 20%, the bank can still sell it off at a price so as to recover the loan amount in full and not lose anything.

In other words, this 20% contribution from the borrower acts as a protective cushion for the lender to get back what it’s owed.

Why 20% (and not 30% or 40%)? 

The bigger the protective cushion, the better for the lender. But keeping the down payment requirement too high deters homebuyers even more (because they need more of their own money to buy the home). 

20% is believed to be an optimal point where lenders are protected in a large majority of scenarios (because a 20% drop in home value and the borrower defaulting at the same time is a low likelihood scenario). At the same time, 20% is reasonable enough for a fairly large number of buyers to buy those homes.

Let’s get back to the importance of PMI and how it helps?

Lenders require 20% down payment, as we now understand. But what if a borrower has less money to buy the home?

Lenders don’t want to risk making a loan with a protective cushion smaller than 20%. They want to help homebuyers, but the more important goal for them is to protect their own capital.

In such a case, for conventional loans (i.e. non-FHA and non-VA loans – More on that later), there are private insurance companies who are willing to take that risk on behalf of the lender in exchange for a monthly premium.

Say, for example, the borrower has only 10% available for down payment. In such a case, the lender will ask the borrower to buy insurance to protect the lender in case of a foreclosure and the property selling for less than the loan amount.

If you are required to buy PMI, the mortgage payment will not only include Principal and interest, it will include an additional payment, the “monthly PMI premium”.

Advantages of disadvantages of PMI 

There is one big advantage and one big disadvantage of PMI.

The advantage – It lets homebuyers buy a home without having to wait till they have the full 20% down payment. 

The disadvantage – The obvious disadvantage is the higher monthly cost for the borrower. 

In other words, people who pay for PMI are those who think that the advantage (of owning a home sooner) outweighs the disadvantage (of paying extra every month).

How much does PMI cost?

According to the Urban Institute, the average range for PMI premium rates was 0.58 to 1.86% of loan amount, as of March 2020 (view report here). This rate is largely a function of Loan-To-Value (LTV) ratio and FICO score. 

The higher the Loan amount (compared to value of the property), the higher the PMI premium. Similarly, lower FICO scores would imply the same. In short, the higher the risk for the insurer, the more the cost of PMI. Just like any other insurance.

Can I choose to cancel Mortgage Insurance policy at any point?

Yes, under certain circumstances. In the beginning, you make a down payment that is less than 20%. But as you make monthly mortgage mortgage payments, you are accruing a little more equity every month (because part of your monthly mortgage is used to pay off your principal). 

If you make your payments as expected, after five years, you’ll likely have more than 20% equity in your home. That can happen even if the price of your home rises. Whenever that happens, you can request your lender to cancel your PMI.

In compliance with the Homeowners Protection Act of 1998, a mortgage servicer is required to automatically terminate the PMI on a non high risk residential mortgage once the equity reaches 22% (or your Loan-To-Value ratio goes below 78%). You can read about it here

Types of PMI and how it is PMI typically paid?

There are two main kinds of PMI

1. Lender-Paid – In the lender-paid PMI option, the lender will pay the PMI. But if they do, the mortgage rate for the loan will typically be higher (than if borrowers were to pay PMI themselves)  
2. Borrower-Paid – As the name suggests, in this case, the PMI will be paid by the borrower. There are several ways to pay this:

1. 1. As a one-time upfront payment – This can sometimes appear to be cheaper. But the problem is that a borrower might refinance or sell the property before breaking even compared to the monthly payment option.
   2. As a monthly payment – This is more preferred mode since you can cancel it whenever you sell the property or refinance.
   3. A hybrid of the previous two. You pay an upfront amount and a monthly payment.

Which of these is better? Well, we would suggest going with the borrower-paid insurance. The main reason is that lender-paid PMI typically comes with a higher mortgage rate. The PMI is temporary whereas the mortgage rate is permanent. 

So you’d rather have a low mortgage rate and a PMI paid out-of-pocket yourself, only because you can cancel PMI later anyway and get to keep the low mortgage rate for the life of the loan.

Do I need to get Mortgage insurance in FHA, VA and USDA loans?

The short answer is yes. All three classes of government-backed loans, i.e. FHA, VA and USDA loans require some form of mortgage insurance.

The reason is that even though they have government-backing, they are loans made by private lenders. The government backing is primarily there to help the low-income borrowers buy a home. But in exchange for this, the corresponding agency of the government that is backing the loan charges a fee. 

FHA Loans – FHA loans are loans insured by the Federal Housing Administration (FHA). They are primarily extended to borrowers with lower credit scores and lower income. 

For such loans, the FHA charges the borrower two kinds of premium called the MIP (Mortgage Insurance Premium) 

• A fixed upfront premium of 1.75%
• An annual premium varying between 0.45% to 1.05%, depending on the loan amount, the down payment and the term of the loan.

Depending on down payment and some other factors, for many FHA loans, you essentially have to refinance into a non-FHA loan to avoid paying MIP.

VA Loans – These are loans backed by the Department of Veteran Affairs (VA), to assist eligible veterans in buying homes. 

There is no insurance premium for these loans but there is a fee called the “Funding Fee”, which as of December 2020 varies between 1.4% and 3.6% (please see here for current fee), depending on the down payment and/or if the buyer is a first-time homebuyer.       

USDA Loans – These are zero down payment loans by the US Department of Agriculture (USDA) for rural homebuyers. 

The insurance for these loans is similar to FHA loans – An upfront guarantee fee of 1% and an annual fee of 0.35% as of December 2020. (You can obtain the most recent numbers on the USDA’s website)

This fee itself changes every year, but for a buyer, it is fixed at the time of purchase for the life of the loan.

Is there anything else I should know about PMI?

Yes, one very important thing to keep in mind when PMI is to keep a close eye on the rate quoted by the lender. Lenders can entice you with a low rate and then charge you a hefty rate for PMI. 

Don’t fall for such traps. Keep a close eye on the total monthly payment.

The other thing to do is this. When comparing two mortgages, always take into account the fact that PMI will likely be canceled after a few years. 

So sometimes, it might make sense to pay a slightly higher rate for PMI when the mortgage rate is significantly lower (compared to a competing quote). That way, your overall cost of the loan is lower for the life of the loan.

Conclusion

I hope the information we provided above was both comprehensive and useful. But if you have any further questions regarding this (or any other topic related to mortgages), we’d love to hear from you at lending@stemlending.com. 

At Stem Lending, our goal is not just to provide great rates. A bigger motive for us is to educate you as much as we can so you can make an informed decision for your mortgage. 

If you are ready to apply, we would love for you to start an application right away at: stemlending.com/apply