If you have been researching home buying and mortgages, you have probably seen the phrase "private mortgage insurance," generally expressed as PMI, mentioned several times. If so, you also probably know that lenders generally require you to obtain PMI if your down payment is less than 20 percent of the home's value.
There is, however, a lot more to know about PMI. Before agreeing to it as part of your mortgage terms, it is important to understand its ins and outs. Once you have learned all you can, you will be able to make an educated decision on whether the home you want right now is worth paying PMI on, or whether you'd rather wait until you can afford a 20 percent down payment.
"Private mortgage insurance exists to protect your lender."
What is PMI?
PMI exists to protect your lender should you default. The policy covers some of the lender's financial loss if the home ends up in foreclosure.
Usually, the cost of your PMI is factored into monthly payments, but sometimes it is possible to pay your PMI costs in a lump sum at closing.
To determine whether or not you need PMI, lenders look at something called your loan-to-value ratio, which is a figure expressed as a percentage describing the amount you owe on your mortgage in relation to the home's value. So, if your mortgage balance is $200,000 and your home's current value is $250,000, your loan-to-value ratio is 80 percent. PMI is usually required when your loan-to-value ratio is over 80 percent. When you first purchase the home, your loan-to-value ratio is determined based on the size of your down payment in comparison to the sale price. Thus, 20 percent down is the magic number that will eliminate the need for PMI.
Whether or not PMI is tax-deductible is determined by Congress every year, so it is unfortunately a bit uncertain. It has, however, been tax-deductible since 2007 and will continue to be in 2016. Whether it is tax-deductible also depends on your income, so make sure to speak with your tax advisor about whether you're qualified.
How Do Lenders Determine the PMI Premium?
Like the other terms of your mortgage, the cost of your PMI will depend on your unique financial situation. The length of your loan, the size of your down payment and your credit score are all factors lenders consider when determining what you'll pay. Costs vary from about 0.2 percent to 1.5 percent of your annual loan balance, which is then divided into 12 monthly payments. Your PMI premium will be lower if you have a strong credit score and put as close to 20 percent down as possible, so spend as much time as you can saving money and practicing good credit behavior.1
Does PMI Last the Entire Length of the Loan?
PMI does not last the entire length of a private loan. In general, you must have it for at least two years, and lenders are required to cancel it when you have built up at least 22 percent equity in your home, or when you still owe 78 percent of the home's current value. When your balance hits that number, the lender will automatically drop your PMI, but you actually have the power to request a cancelation a little earlier, when your loan balance hits 80 percent of the home's current market value.2
If, however, you have not been making regular, on-time monthly payments or fail to meet other necessary provisions, the lender may not be required to cancel your PMI. When taking out the loan, spend some time asking your lender what behavior would result in an inability to cancel your PMI even once the acceptable amount of equity is reached. That way, you can work hard to make sure you do everything right.
It is also vital to keep in mind that PMI is only temporary if your mortgage is not government-backed. If you are planning to obtain an FHA loan with less than 20 percent down, you will have to pay insurance for the entire life the loan. VA loans, on the other hand, do not require mortgage insurance.
Your PMI rules may also be different if your loan was labeled "high-risk" when you took it out, so make sure to ask your lender about your eligibility for future cancelation before agreeing to the loan.
Borrowers with a second mortgage must remember that what they owe on it will also affect the amount of equity they have.
If you want more information on how PMI premiums might factor into your mortgage, contact an expert Loan Officer at New American Funding today. We'd be happy to help you move one step closer to the home of your dreams.