Buying a home is a multi-step process. In addition to finding the right home and managing negotiations with the seller, there is also the financial process to navigate. Before you even make a bid on your house, you need a pre-approved mortgage ready to be finalized as soon as negotiations are through. Additionally, to get your mortgage approved, you may be asked to include something called PMI or private mortgage insurance.
Just what is PMI, and why does it add a monthly or initial cost to your mortgage? Here is a quick guide to answer all your essential questions about private mortgage insurance.
What is Private Mortgage Insurance?
Private Mortgage Insurance (PMI) insures your ability to pay a mortgage. It pays the bank should you default on your mortgage. PMI is often required when your mortgage down-payment is less than 20% of the home value. Because so many homeowners buy their first (and further) homes with less than 20% down payment, PMI has become a standard part of the mortgage process.
PMI protects the lender, not the homeowner. But it is paid as an insurance premium bill by the homeowner in order to protect a loan deemed higher risk - due to the low down payment.
What are the Different Kinds of PMI?
1. Buyer-Paid Mortgage Insurance (BPMI)
- With BPMI, you pay a monthly insurance premium along with your mortgage payment.
- BPMI payments may be wrapped directly into your mortgage for one slightly larger monthly payment.
2. Single-Premium Mortgage Insurance (SPMI)
- In SPMI, you pay one lump premium at the beginning of the mortgage.
- Considered a closing cost for the house and mortgage.
- SPMI payments are non-refundable if you refinance later for a better rate.
3. Split-Premium Mortgage Insurance
- Lump premium sum at closing & monthly premiums alongside mortgage payments.
- Lump sum is non-refundable but monthly premiums change with refinance.
- Good option for those with a high debt-to-income ratio.
4. Federal Home Loan Mortgage Protection (MIP)
- Only available for FHA home loans.
- Required at downpayments of 10% or less instead of 20%.
- Lifted after 11 years minimum or with refinancing.
- Typically split-premium payments.
5. Lender-Paid Mortgage Insurance
- While the lender pays for this type of insurance, the borrower ends up paying the cost via higher interest rates over the course of the loan.
- Ability to reduce monthly payment by refinancing, but otherwise the interest rate will not shrink after reaching 20% equity.
Why Do You Need Private Mortgage Insurance?
Private mortgage insurance protects lenders from potentially high-risk home loans. This allows the overall system to help more buyers successfully purchase houses without impacting the lending institute's ability to offer loans. Most people who buy houses manage their loans responsibly, keeping up with payments and refinancing as needed. But because the smaller number of people who default could realistically cost the lenders hundreds of thousands of dollars for each defaulted mortgage, it's important for potentially risky loans to be insured.
You take out mortgage insurance so that the bank can, by the numbers, afford to offer loans to families with less than 20% of the home's value to put down on the loan. Because the fact of the matter is that good lenders want you to succeed at paying your mortgage, and to foreclose as little as possible.
When Do You Need Private Mortgage Insurance?
PMI is needed when home buyers put down less than 20% on a mortgage loan. Because the bank is paying the sellers the full amount for the house, your down payment is paying a portion of that total cost back to the bank initially. The less a buyer puts into the down payment, the more a lender has to lose. This is why PMI is required when buyers can put down less than 1/5 of the home's value at the time that the bank makes their payment to the seller.
Can You Get Rid of PMI on Your Loan?
The good news is that you do not have to pay PMI forever. In fact, according to the federal Homeowner's Protection Act, lenders must cancel your PMI policy and payments after you have reached 22% equity on the home. You can apply with your loan officer to have PMI removed after you have reached 20% equity.
Homeowners may also be able to get rid of PMI before reaching 22% equity with their current loan by refinancing. With historically low interest rates and more equity to put on the house, you can likely get better terms for a refinanced loan today if you are still paying PMI on your current home loan. Talking to a loan officer can help you get an idea of what refinancing options are available and if refinancing or a PMI removal application is the right choice for your mortgage.
Please note, by refinancing your existing loan, your total finance charges may be higher over the life of the loan.