PMI Explained: A Comprehensive Guide to Private Mortgage Insurance
If there’s one thing that no first-time homebuyer wants to hear, it’s that they need to pay for private mortgage insurance (PMI).
But what is PMI, and why is it harmful to homebuyers? Keep reading to learn more.
What is PMI?
PMI, which stands for private mortgage insurance, is a fee that lenders charge to high-risk borrowers. Higher-risk applicants can be problematic for lenders because defaults are extremely costly. As such, lenders try to reduce risk wherever possible.
In other words, if your mortgage lender determines there’s a higher-than-average chance of you not paying back your loan, they tack on private mortgage insurance. The bank is also likely to charge higher interest rates in these situations.
For the lender, PMI insures the loan in the event that a borrower defaults, meaning that the lender does not have to eat the cost of the default. Instead, the lender’s insurance covers the loan losses, similar to how auto insurers pay for the costs associated with a car accident.
Unfortunately, for the homeowner, PMI often means a few hundred dollars worth of extra fees each month—without getting anything back in return other than the opportunity to take out a mortgage loan.
When is PMI Required?
Lenders traditionally require borrowers to pay PMI if their down payment is less than 20% of the home’s purchase price. This is because when a borrower is not able to save up at least 20% for a down payment, it raises a few red flags.
For example, perhaps the borrower doesn’t have solid cash flow. Also, when a borrower only puts down 5%, their debt-to-income ratio is negatively affected.
Less of a down payment equals more debt, which equals a higher risk of default.
PMI may also be required when refinancing and taking out a mortgage that’s greater than 80% of the appraised value.
Homeowners insurance vs. PMI
PMI is fundamentally different from homeowners insurance, so it’s important to not get them confused.
Homeowners insurance is designed to protect the homeowner’s property and furnishings from damage. While most lenders require borrowers to carry it, homeowners insurance primarily benefits the borrower and not the lender.
Private mortgage insurance, on the other hand, is for the bank’s protection. It’s designed to help the bank absorb costs should you default on your loans and go through foreclosure.
PMI vs. FHA mortgage insurance
PMI and FHA mortgage insurance function in very similar ways.
PMI is required with conventional loans (e.g., when a borrower finances their house from a traditional mortgage lender and puts less than 20% down).
On the other hand, when a borrower takes out a Federal Housing Administration loan (FHA loan) and puts down less than 20%, FHA mortgage insurance is required. These fees are known as mortgage insurance premiums (MIPs).
The main difference is that private mortgage insurance protects the bank’s interests while FHA insurance protects the federal government’s interests.
The Cost of PMI
In general, PMI rates range from about 0.5% to 1% of the entire loan annually. So that means if you buy a house for $200,000, you could pay upwards of $2,000 per year just on PMI. That’s a whopping $166 per monthly mortgage payment on something that gives you nothing more than the ability to carry a mortgage. Remember: private mortgage insurance doesn’t build home equity.
The actual cost of PMI payments depends on a few different factors. The mortgage lender will consider the type of loan, the term of the mortgage, and your credit score.
They’ll also consider something called the loan-to-value ratio (LTV). To calculate LTV, divide the amount of the mortgage by the value of the property. The higher the LTV, the higher the PMI rate you can expect–especially when the LTV exceeds 80%.
Some types of mortgages also contain specific PMI requirements, which may be outside of the lender’s control.
Does PMI Benefit a Homebuyer in Any Way?
While “private mortgage insurance” isn’t something you want to hear when negotiating with a bank, it’s not always bad.
First and foremost, it enables borrowers with higher risk profiles to secure property in spite of their risk, and prevents banks from being overly cautious when distributing loans.
What’s more, PMI enables buyers to put less money down when buying a home. For example, you may only have enough money in savings to put 10% to 15% down on a property in a lump sum. In this case, the lender may issue PMI as a way to absorb risk, without preventing the buyer from potentially closing the deal.
How to Avoid Paying PMI
As you can see, you generally want to avoid paying PMI at all costs. Here are some ways to get around this costly monthly fee.
1. Save more money
The best way to avoid PMI is to put at least 20% down on your home purchase. Furthermore, the more money you put down, the lower your mortgage payment will be every month.
Work hard to save up as much money as you can so that you can put more towards your down payment.
2. Ask the lender to cancel PMI
In some cases, it could make sense to take on PMI and close on a property just for the sake of getting a great home at a decent price.
Once you get the property, make monthly payments until the mortgage drops to below 80% of the purchase price.
At that point, you can either ask the lender to cancel PMI, having demonstrated that you are a worthy borrower. Another thing you can do is refinance for a better mortgage rate.
3. Wait for automatic cancellation
If you’re patient and don’t want to go through the hassle of negotiating with the lender or refinancing (which can be costly due to appraisal fees and closing costs), you can simply wait until the principal balance drops to under 78% of the total home value.
When this happens, the lender is required to cancel private mortgage insurance automatically.
Another checkpoint for automatic PMI cancellation occurs at the halfway point in a mortgage: either 7.5 years for a 15-year mortgage or 15 years for a 30-year mortgage.
Tips for Managing PMI
If you get stuck dealing with PMI, don’t get dismayed. It’s not a permanent problem and will go away in a few years as you make consistent payments on your mortgage.
That said, there are a few proactive things you can do in the meantime to help deal with the added stress of a high monthly mortgage payment.
Pick up a side hustle
Consider getting a second or third job to offset the financial loss of paying PMI.
By working a side hustle, you can easily earn a few hundred extra bucks each month, covering your PMI costs and beyond.
On that note, one of the most popular side hustles for a homeowner is renting your space on a site like Airbnb.
If you do this regularly, you can bring in hundreds or even thousands of dollars per month, giving you extra funding to put towards your loan balance.
Some people even choose to convert their single-family home into a multi-family home with a separate entrance so that they can continuously rent a portion of their house and bring in extra cash.
Improve your credit score
Keep making credit card payments to improve your credit score and put yourself in a better position to refinance. By having a better credit score, you can potentially renegotiate your mortgage and get out of paying private mortgage insurance earlier than expected.
Get the best rate on your home insurance
If you have expensive PMI, then you’re going to need to scour the market and look for the best possible homeowners insurance. Shop around and don’t be afraid to switch providers if you find a better offer.
Get a roommate
Living alone and dealing with high payments can be tough. If you have the extra space—and the ability to live with others—consider getting a roommate to bring in extra cash.
In addition to covering your PMI costs, the rent that your roommate pays can also pay a significant portion of your monthly mortgage payments.
The Pros and Cons of PMI
Here is a breakdown of the pros and cons of PMI:
- Enables higher risk buyers to secure a house
- Allows you to put less than 20% down on a mortgage
- Not all loans come with PMI requirements
- High annual fee of 0.5% to 1% of the total loan amount
- Benefits the bank, not the buyer
- Mandatory for some types of loans
Frequently Asked Questions
Do all loans require PMI?
Not all loans require borrowers to purchase PMI. For example, VA loans do not require private mortgage insurance, regardless of how much money the buyer puts down.
Can I get out of paying PMI premiums?
There are a few ways to get out of monthly premiums (see above).
The easiest thing to do is to make payments and request a cancellation from your lender after reaching 22% equity. You can also simply wait for automatic cancellation or refinance.
Does the cost of PMI drop over time?
Unfortunately, PMI does not drop in value as you make more payments. It’s based on the original value of the home’s purchase price.
The Bottom Line
There are many hidden costs associated with investing in real estate, and PMI is one of the top costs to consider. If you want to get a home loan and don’t have a bunch of money in your savings account, there is a strong chance you’re going to have to pay it.
That said, there are some ways out of paying PMI, and it’s not a forever problem. What’s more, the benefits of homeownership typically far outweigh the inconvenience of higher payments for a few years.
So, if the bank requires you to pay PMI, factor that into your budget. Are you positive that you can afford all of the monthly costs of owning a home, including your monthly mortgage premiums, PMI, utilities, taxes, and repair costs?
If so, it’s time to move forward with your home purchase. If not, there’s nothing wrong with renting for another year or two so you can save up a bigger down payment.
Here’s to finding an affordable home loan that aligns with your personal and financial goals!