In today’s mortgage marketplace, prospective homebuyers often struggle to come up with the minimum 20% down payment. Fortunately, there are several loan programs that allow borrowers to obtain financing with down payments as low as 3.0%. While these loans make homeownership more affordable, they do come at a cost.
To offset the risk of lending to these buyers, lenders require these borrowers to pay mortgage insurance. When considering your home loan options it’s important to understand whether you’ll need to pay mortgage insurance, and how it might affect your monthly mortgage payment moving forward.
Different Types of Mortgage Insurance
There are two types of mortgage insurance: private mortgage insurance, or PMI, and mortgage insurance premiums paid to the government, which covers USDA loan borrowers and loans obtained through the FHA (this type of insurance is also known as MIP).
If you secure a government-backed mortgage, such as an FHA loan, you’ll actually be required to pay two types of mortgage insurance: a one-time upfront mortgage insurance premium, or UFMIP, and a monthly insurance payment. Typically, the UFMIP is about 1.75% of the total loan amount and is due at closing, while the annual premium is generally less than 1% and is paid with your monthly mortgage payment. Similarly, VA loan and USDA loan borrowers may also be required to pay equivalent forms of UFMIP or monthly premiums.
What is Private Mortgage Insurance?
Private mortgage insurance is a policy that protects your lender if you fall behind on your mortgage payments or end up in foreclosure. It’s a monthly fee paid by borrowers on top of their regular mortgage payment and can covers most non-government backed loans, such as a conventional mortgages.
While insurance premiums differ based on the buyer’s insurance provider, personal credit score and size of down payment, PMI typically ranges from between 0.3% and 1.5% of the total loan on an annual basis.
For example, if your loan is $180,000 and you carry an insurance rate of .40%, then you’ll be required to pay $720 in PMI a year. In other words, you’ll need to add $60 to your monthly mortgage payment.
It’s important to note that PMI shouldn’t be confused with homeowner’s insurance, which is a separate insurance policy homebuyers purchase to protect themselves from the high costs of home damages. That fee is collected by your lender and placed into a mortgage impound escrow account, where it is then distributed to the appropriate agencies by the bill’s due date.
Can You Avoid Mortgage Insurance?
If you put down less than 20% for your down payment, chances are you’ll be on the hook to pay private mortgage insurance. The only way to avoid PMI is to bring more cash to the closing table—or to take out a so-called piggyback mortgage to make up for a down payment shortfall.
A piggyback loan, or an 80/10/10 agreement, is actually a type of Home Equity Line of Credit (HELOC). It’s a second loan taken out on top of your mortgage. If you’ve saved up enough money to put down 10% on your mortgage, you may be eligible to take out a piggyback loan to make up the other 10%, thus meeting the 20% requirement.
Though these loans allow you to avoid paying mortgage insurance, they often come with trade-offs that you should consider, such as adjustable-rates or balloon payments.
You’ll need to take a look at your budget to see if it makes financial sense. It may be better to call on family or friends for a cash gift or loan—or agree to pay a higher interest rate, instead.
How to Remove PMI
For most conventional loans, private mortgage insurance can be cancelled once the borrower has reached 20% equity in their homes. To figure out if you’ve reached this threshold, you’ll need to calculate your Loan-to-Value (LTV) ratio. You can do this by dividing how much you still owe on the home’s by its original purchase price.
For example, if you purchased a home for $205,000 and you’ve managed to pay off $60,000, your LTV is 0.775 (because you owe $150,000), thus making you eligible to cancel PMI.
Unfortunately, PMI doesn’t automatically cancel. You must submit a request for PMI cancellation in writing, and you must meet the following requirements:
- Be current on all your monthly mortgage payments, and have a solid payment history.
- Ensure you don’t have any other liens against the home (such as a home equity loan).
- Provide a home appraisal to ensure you don’t owe more than 80% of the home’s value.
You should have a good idea of where you stand by reviewing your annual statement from your lender. Your lender is also required by law to provide you with a PMI disclosure form, which includes the necessary steps and a general timeline for when you can expect to cancel your mortgage insurance. You should receive this document at closing.
It’s also important to note that many current FHA loan programs include life-of-loan mortgage insurance, which means that homeowners are not able to cancel their mortgage insurance.
Want Out of Mortgage Insurance? Refinance
Even if you are an FHA homeowner, you may be eligible to refinance into a new conventional loan and eliminate mortgage insurance altogether. In fact, switching to a conventional mortgage may actually lower your monthly payment, even if the new loan’s interest rate is a bit higher.
To be eligible for a refinancing, you’ll need to have solid credit, and a history of on time payments. You’ll also need to present several documents proving your financial ability, including W-2s, recent paystubs, a statement of debt and assets, and other items.
If you can’t provide these documents, you may be eligible for a streamline refi, which can ease the process and still help you reach your refinancing goals. Note that while a streamline refi may save you money, you will still be paying for mortgage insurance with this type of loan.
Refinancing can be especially beneficial if your home’s value has increased over the years since you first purchased it. That being said, refinancing does come at a price. You’ll still be on the line for closing costs, title searches, appraisal and underwriting fees, and more. Be sure the savings of refinancing outweigh the expenses.
Have Questions About PMI?
While many borrowers may gripe about the costs of PMI, the reality is paying these costs often provides a quicker, more affordable path to homeownership. Without PMI many people would be forced to wait a few more years to save for a higher down payment. It’s a tradeoff, but not one that many people would forgo.