The Basics of Private Mortgage Insurance (PMI)

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When you think about buying a house, you naturally think about getting a mortgage loan, then HOA fees, homeowners insurance and taxes. But how often do you think about insurance on a mortgage loan? If you’re buying a home with a down payment of less than 20% of the home’s value, then having private mortgage insurance (PMI) is something you might need to think about in your financial decision making.

What is PMI?

Private mortgage insurance is a type of mortgage insurance that is provided by private insurance companies to be used with conventional mortgage loans. The primary purpose of mortgage insurance isn’t to protect the borrower, even though the borrower pays the premiums. The purpose of PMI is to protect the lender from the borrower defaulting on their mortgage payments. If the borrower can’t make monthly payments, the lender is reimbursed by the insurance company that issued the PMI.

Who needs PMI?

Borrowers are typically required to get PMI if they take out a conventional mortgage, and give a down payment of less than 20% of the home’s value.Remember, PMI is for the lender, not for you. If the bank feels like you’re a high risk for loan default, then they’ll want you to get PMI. That way, if you default on your loan and the housing prices take a dive, the bank will still be able to recover their investment.

How much does PMI cost?

The cost of PMI payments can vary greatly from person to person, because the premium is calculated based on the loan-to-value ratio, loan size, loan type, credit score, amount of coverage and premium type. Home location alone could have a significant effect on your premiums as well. Thankfully, it’s a relatively simple concept. The greater the risk, the higher the premium. If you have a bad credit score or your down payment is only 10%, the risk to the lender is much higher, resulting in a higher premium.

What are the payment options for PMI?

There are three main payment options for PMI.
1. PMI premiums are typically paid monthly as part of the overall mortgage payment to the lender.
2. Lender-Paid Mortgage Insurance, or LPMI. This is paid for by higher interest rates.
3. Single premium PMI.

The downside of LPMI is that you’ll have to maintain those higher interest rates until you refinance or pay off the loan.
The single premium PMI is a good option if you have the cash to pay the premium and want to sustain a lower monthly payment. It typically requires a monthly payment of 1-2% of your loan amount.

How long will I be paying for PMI?

The good news about PMI is that you won’t be paying it forever. Your lender is required to automatically cancel PMI when your loan balance drops to 78% of the home’s original value. If you’re willing to take the extra time to keep watch, you can drop PMI sooner by requesting cancellation when your balance reaches 80% of the home’s original value. The rate at which your loan balance drops depends on your amortization schedule. This is a fixed repayment schedule that initially works to pay off interest towards the end of the loan term. Below is an example of a simplified version of an amortization schedule:

pmi_amortizaton

With this amortization schedule, your balance would reach 80% ($160,000) in around 11 years.

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