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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 a large down payment, 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 at closing – the downpayment.

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.

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.

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). 

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

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

Lenders 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 few liquid funds 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 a large 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).

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. 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 LoansFHA 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
  • An annual premium, 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”,  (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 and an annual fee. (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. Feel free to contact us for a complimentary quote.

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 [email protected] / 833-600-0490

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 get a quote right away at: stemlending.com/quote

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