When you start making your first mortgage payments, you may be in for a bit of a surprise. In addition to the amounts of money that are allocated towards the principal and interest of your loan, you might see an additional charge for something called private mortgage insurance, or PMI.
Private mortgage insurance is a type of policy that only applies to specific conventional loans. It’s an annual fee you pay monthly or as a lump sum, and you won’t need to make these payments for the lifetime of your mortgage. But, if you do find yourself owing PMI, it’s important to understand what it is, how it works and how to satisfy this lending requirement.
What Is Private Mortgage Insurance?
Private mortgage insurance is an insurance policy that protects your lender from losing money if you default on your loan, meaning you stop making payments in a way that meets your original loan requirements. Lenders typically require borrowers who are deemed high-risk to pay for private mortgage insurance. This arrangement can last until a lender agrees that the borrower has built up enough equity in the loan. At that time, the borrower is no longer a higher risk for the lender.
A lender usually requires a borrower to pay for private mortgage insurance when the down payment for their conventional loan is less than 20% of the purchase price. Without private mortgage insurance, lenders aren’t willing to take on the risk of lending money to people who are unable to make a considerable down payment.
In addition to paying a higher down payment when buying a home, there are several strategies you can use to avoid paying private mortgage insurance. In most cases, private mortgage insurance doesn’t apply to a non-conventional loan, even in the case of 100% financing, which happens when the lender gives you a loan for 100% of the home’s value. This is a situation in which you have no down payment. The U.S. government typically backs these non-conventional loans, so the lender doesn’t need additional protection against defaults on mortgage payments.
What Does Private Mortgage Insurance Do?
As the name suggests, private mortgage insurance is an insurance policy. It’s for your mortgage lender, and you cover the cost of it on your lender’s behalf. Its purpose is to offset the potential financial loss the lender could face if you stopped paying your mortgage and the lender wasn’t able to recoup the cost of your loan another way.
If you’re making a down payment that’s less than 20% of the home’s purchase price on a conventional mortgage loan, you’re considered a higher risk for the lender than someone who makes a down payment of 20% or more. In other words, the lender believes you’re statistically more likely to default on your mortgage when you don’t have the 20% available. If you don’t have enough savings to pay a larger down payment, the lender reasons, then you’re unlikely to have enough savings to continue paying your mortgage if you lose your job.
Although a lender can foreclose on a borrower who defaults on their mortgage, there’s no guarantee that the home will be in salable condition or the real estate market at the time of foreclosure will be strong enough for the lender to earn back the money it originally paid for your home at your time of purchase. Depending on these and other circumstances, the lender could lose a significant amount of money on your loan.
That’s why lenders take out private mortgage insurance policies on high-risk borrowers. This insurance policy can pay the difference if the borrower defaults and the lender can’t recoup the value of the original mortgage loan through the foreclosure process.
How Does Private Mortgage Insurance Work?
The lender will require you to pay for private mortgage insurance if your home’s loan-to-value ratio is higher than 80%. This means that the amount of your mortgage loan is higher than 80% of your home’s value. This is the case at the start of a loan when you make less than a 20% down payment. You’ll need to pay for private mortgage insurance until you pay the principal of your mortgage loan down by at least 20% through monthly payments. This is also the case when you refinance and don’t already have at least 20% equity in your home.
As soon as the loan-to-value ratio reaches 80% or less, the lender will permit you to stop paying for private mortgage insurance. Like other forms of insurance, rates for private mortgage insurance vary. Higher private mortgage insurance premiums cost about 2% of a mortgage’s value per year.
Can You Avoid Paying Private Mortgage Insurance?
You can avoid paying private mortgage insurance by starting off your mortgage with an 80% or less loan-to-value ratio. This happens when you make a 20% down payment or borrow at least 20% less than the total purchase price without making a down payment.
If it’s allowed under the terms of your mortgage, you can get a second mortgage, called a piggyback mortgage, to cover the down payment cost if you won’t be able to pay at least 20%. You’re still responsible for making both mortgage payments — and one will cost much less than the other — but you avoid paying for private mortgage insurance.
Remember, a mortgage is a contract. Although there will be some standard provisions you might not have the option to change, nearly everything else is negotiable. Some lenders are willing to pay private mortgage insurance on behalf of a borrower. In exchange, you pay a higher interest rate for the entire term of the mortgage, but your lender will stop paying private mortgage insurance on your behalf when your loan-to-value ratio rises above 80%.
Paying Your Private Mortgage Insurance
Private mortgage insurance is typically represented by a percentage of your total loan amount. You pay that percentage each year until your loan-to-value ratio falls below 80%. You can either pay private mortgage insurance as an annual lump sum, or you can have the cost split across your mortgage payments for the year. When you buy a home, you may need to pay some of the private mortgage insurance at the time of closing, even if you’ll pay the remainder monthly.
The cost of private mortgage insurance is a surcharge you pay in addition to your mortgage payment, and the full amount goes towards the insurance policy. This means the portion of your monthly mortgage payment that goes towards private mortgage insurance doesn’t reduce the principal of your mortgage or cover any interest on it.
If you’re unable to make a 20% down payment and are concerned about owing private mortgage insurance, it may be wise to consider FHA or USDA financing. There are also local down payment assistance programs that can help you with this cost. When you’re budgeting for a mortgage, be sure you consider the added cost of private mortgage insurance if your down payment will be less than 20% of the home’s price.