If you are going to use a mortgage to finance your home purchase, you might encounter the term “private mortgage insurance.” In this brief but comprehensive guide, we will help you understand what this conditional requirement means and what you can do to avoid it as a borrower.
What is private mortgage insurance?
Private mortgage insurance (PMI) is a measure that lenders use for their protection in case of a borrower defaulting on their loan.
While it is an additional recurring expense, incurring private mortgage insurance is a worthwhile tradeoff to secure favorable loan rates if the borrower is unable to pay a substantial down payment.
When is a PMI required?
Lenders compute for the loan-to-value (LTV) ratio of a mortgage during the underwriting process. This figure is derived when the principal amount of the loan is divided by the actual value of the property.
Simply put, a higher LTV ratio suggests a higher risk profile for the loan. Mortgages with an LTV ratio higher than 80% typically require the borrower to pay PMI.
For example, if you are buying a house valued at $600,000 and you pay $90,000 as down payment, you are borrowing $510,000. The loan-to-value ratio is 85%. Most lenders will consider this loan high-risk and will require you to pay private mortgage insurance.
How much do regular PMI payments cost?
On average, annual PMI premiums range from 0.55% to 2.25% of the original loan amount.
For the $510,000 loan we are using as an example, this means you may be required to pay an additional $2,805 to $11,475 every year. This goes on top of your mortgage payments and other recurring expenses as a homeowner.
The amount of your PMI payment is also determined by the type of mortgage that you are using. If you choose an adjustable-rate mortgage, for instance, you will likely pay a higher rate than if you were using a fixed-rate loan.
How can I avoid paying PMI?
The simplest way to avoid incurring a private mortgage insurance obligation is to pay a down payment of at least 20% of the purchase price. Lenders generally do not consider borrowers who own 20% of a property’s value as high-risk.
If you are unable to pay a 20% down payment, you can consider these two alternatives:
- Take out a “piggyback” loan to lower your loan-to-value ratio. Apply for one mortgage that covers 80% of the purchase price, then use a second loan to cover another 10%. Pay the remaining 10% as your down payment.
- Choose lender-paid mortgage insurance (LPMI) terms. Negotiate with your lender to include the PMI in the mortgage interest rate for the entire duration of the loan. This will increase the total amount you pay in interest, however.
Note: PMI is not a permanent requirement
As a borrower, keep in mind that you are not required to pay PMI throughout the life of your mortgage. PMI payments are automatically cancelled once you obtain 22% equity in the property.
However, you can request the termination of your PMI obligations as soon as your mortgage balance drops to 80%. We recommend that you do this so you don’t waste money paying PMI for the remaining 2%.
Let Urban Luxe Real Estate be your guide to understanding technical and unfamiliar terms in the homebuying process. Consult with this leading team of expert realtors in Phoenix, Arizona by calling 480.359.6519 or by sending an email to info(at)urbanluxere(dotted)com.