Private Mortgage Insurance
What is PMI?
Private mortgage insurance (PMI) is a type of mortgage insurance that is required if you purchase a property with less than 20% down. When you put less than 20% down (the typical down payment for most mortgages), the lender is carrying significantly more risk and protects itself by adding this PMI premium. In almost all government-backed loans (conventional, FHA, USDA, and VA loans sold to Fannie and Freddie), there will be a PMI premium.
What Does PMI Cost?
The amount of PMI typically ranges from 0.5% to 2.5% of the purchase price annually. The actual amount you pay will differ greatly based on the price of the property, how much you put down, and your credit score.
For example, if you buy a $300,000 house with 18% down and you have a credit score of 800, you will likely be closer to that 0.5% premium. In other words, you would pay $1,500 per year in PMI or $125 per month. If you bought that same $300,000 house, but with 1% down and a credit score of 625, you will likely be closer to that 2.5%. This will translate to $7,500 or $625 per month.
Luckily, you will know about what your PMI premium is before you actually close on the loan. Be sure to include it in your numbers. As long as the rent is well in excess of the entire mortgage payment (including PMI), it should not stop you from closing on the loan.
Why is PMI Important?
PMI allows those with less than 20% down to invest in real estate. Think of it as a negotiation tool. The lender will only give people loans that are at least 80% loan-to-value (20% down payment). However, we are able to convince that lender to give us a higher loan amount of 97% loan-to-value (3% down) if we just pay them a little more each month.
Without PMI, the lenders would not have an added incentive to hand out a mortgage with less than 20% down. It’s more risk and with the same amount of reward for them. PMI allows people to house hack and get started in real estate investing. For many first-time investors, it may take them 7-10 years to save up for that first down payment of 20%. By reducing the down payment to as little as 1% to 3%, it allows them to get started five to 10 times sooner.
How Do I Make PMI Payments?
Different lenders and loan products will give you the option as to how you pay PMI. The borrower can opt to make a lump sum payment at the beginning of each year. This typically is cheaper, but you will not get it back if you decide to refinance.
The most common method is simply having the monthly amount rolled into your mortgage. You will be able to see this exact amount when you go over your loan with your lender.
The third and least common option is a hybrid of the two. You make a partial up front payment and roll the rest into your monthly mortgage.
What Are the Drawbacks?
The most obvious drawback is the cost. PMI will range between 0.5% and 2.5% of the overall loan. Depending on the size of the loan, that additional monthly cost may be significant enough for you to go from easily making payments to struggling to make payments.
No Longer Tax-Deductible
Up until 2017, the tax-payer used to be able to deduct PMI. Not anymore. With Trump’s revamping of the tax code, there is no longer a deduction for PMI.
Family Gets Nothing
The name “private mortgage insurance” can be a bit misleading. The “insurance” is not insuring you. It is insuring your lender in the event that you default. Except, rather than them paying for it, you are. In no way does private mortgage insurance protect your family or heirs if anything were to happen to you.
Hard to Cancel
If you have an FHA loan, the PMI stays with you throughout the remainder of the loan. The only way to get out of it is to refinance, which is another process in and of itself. If you have a conventional loan, the PMI will burn off once you reach 20% LTV, but that will typically take 7-10 years.
Ways to Avoid PMI
There are a few ways to get out of paying PMI.
Put 20% down
Find a portfolio lender: Portfolio lenders are those that keep their loans on their own books. In other words, they don’t sell their loans to Fannie or Freddie, so they are able to be more flexible. However, with more flexibility comes higher interest rates. While you may not pay PMI, your interest rate may be higher, which may not ultimately make a big impact on your monthly payment.
80/10/10 agreement: Some lenders will offer an 80/10/10 agreement. With this strategy, you take out your normal 80% loan that would avoid PMI all together. You then take out an additional loan for 10%, and then you only put 10% down yourself. This can be risky because that additional 10% loan may have crazy terms, including balloon payments, adjustable interest rates, etc.
Check out this article to read more about PMI.