I’m sure most prospective homeowners like the idea of putting little to nothing down when purchasing a property, but doing so isn’t without its drawbacks.
In fact, it can cost you quite a bit of money if you don’t come to the closing table with a sizable down payment. Aside from having a larger mortgage payment, you might also be hit with an extra form of insurance.
When is mortgage insurance required?
Borrowers who take out conventional loans (those not guaranteed by the government) and are unable to come up with a 20% down payment, or simply don’t want to, must pay “private mortgage insurance,” also known as PMI, to obtain a mortgage.
It is required by the bank or lender providing financing if the loan-to-value, or LTV, is greater than 80%. So those who fail to come up with a 20% down payment are stuck paying PMI.
For the record, some lenders may tell you that mortgage insurance isn’t required even if your LTV is above 80%, but it’s likely just factored into the (higher) interest rate. So you still pay it, just not directly.
What is private mortgage insurance for?
In short, it’s all about risk and protection. A mortgage with no down payment is more likely to default than one with a large down payment. And even if a borrower with a huge down payment misses their payments, the lender can still sell the home for a profit if it falls into foreclosure.
If it’s a no-down payment loan and home prices take a dive, it could turn into an underwater mortgage, which would equate to a loss for the lender when they attempt to offload it.
So PMI is important because it protects the originating bank or lender when a borrower with a very high LTV defaults on their mortgage. That’s right, PMI is insurance for the bank, not for you.
If you default on a loan with PMI in-force, the lender will receive a payout from the private mortgage insurance company to cover the associated losses.
It is also said to benefit borrowers by allowing them to finance a property with very little down in one single loan, which I suppose is true, but it does come at a cost.
For example, homeowners can obtain 95% LTV financing or higher if they agree to pay private mortgage insurance, without requiring a large down payment.
How much does private mortgage insurance cost?
The cost of private mortgage insurance can vary greatly and carries its own pricing adjustments, just as the associated loan will.
The greater the combined risk factors, the higher the cost of PMI, similar to how a mortgage rate rises as the associated loan becomes more high-risk.
So if the home is an investment property with a low FICO score, the cost will be higher than a primary residence with an excellent credit score.
Per the Insurance Information Institute (III), mortgage insurance premiums can range from $250 to $1,200 per year, though it’s not uncommon to pay several hundred a month for coverage if you’ve got a large loan amount and very little down payment.
Let’s look at a quick example:
$200,000 purchase price
$190,000 loan amount
0.70% of loan amount for annual mortgage insurance premium (paid monthly)
In the scenario above, you’d be looking at a cost of $110.83 per month for coverage.
If the mortgage is above 95% LTV, the annual mortgage insurance premium might increase to something like 0.90%. In general, a higher LTV equates to higher risk and premium.
Keep in mind that PMI can also be paid upfront or by the lender instead, with the latter resulting in a higher mortgage rate as a result.
The Homeowners Protection Act of 1998 (How to Get Rid of Mortgage Insurance)
I’m assuming the most popular question with regard to private mortgage insurance is how to cancel it? Fortunately, there are many ways it can be canceled.
In the past, homeowners continued to pay PMI even after their LTV fell below 80% because the banks and mortgage lenders were not required to notify borrowers. It used to be the responsibility of the borrower to cancel PMI once they reached the 80% LTV mark, but recent laws have forced the banks and lenders to take responsibility as well.
Automatic Termination of PMI
All the confusion led to the Homeowners Protection Act of 1998, which established rules regarding termination of private mortgage insurance on principal residences.
The law requires home mortgages signed on or after July 29, 1999 to automatically terminate PMI once the homeowner reaches 78% LTV, or gains 22% equity in their home, based on the original property value (lesser of purchase price/appraised value).
Just note that you must be current on your mortgage when you hit 78% LTV to get PMI removed. If you aren’t, it will be automatically terminated on the first day of the first month following the date that you become current.
Borrower Requested Termination of PMI
The law also allows homeowners to request the termination of PMI once they gain 20% home equity, or 80% LTV of the original value. So at that time you can contact your lender and ask for the PMI payments to cease. But they won’t contact you, so you’ve got to keep an eye on your loan amortization schedule to figure out when you’ll hit that key level.
If you happen to make extra mortgage payments and/or your property has increased in value (or if you made documented improvements to your property), you might be able to submit a request for cancellation even faster. But you may have to pay for an appraisal, so bear that in mind.
And you must have a good payment history (no 30-day late payments in the past year or 60-day late payments in the past two years), be current on your loan, and submit a written cancellation request.
Final Termination of PMI
The Homeowners Protection Act has one final option to remove PMI. If for some reason PMI was not canceled by request or automatic termination, the loan servicer must cancel mortgage insurance by the first day of the month immediately following the midpoint of the loan’s amortization period.
Again, the borrower must be current on their mortgage on this date for this rule to go into effect.
Mortgage servicing companies must provide a telephone number for all their mortgagors to call for information about termination and cancellation of PMI. And new borrowers covered by the law must be told – at closing and once a year – about private mortgage insurance termination and cancellation.
The Homeowners Protection Act of 1998 does come with some exceptions though. If your loan is considered “high risk”, if your property has additional liens, or if you were not current on your mortgage within the year prior to termination or cancellation, you could be stuck with PMI until those issued are resolved.
Though the law does not cover loans that were signed before July 29, 1999, or loans with lender-paid MI, lenders or mortgage servicers must tell borrowers about the termination or cancellation rights they may otherwise have with such loans (including rights established by the contract or state law).
If you signed loan documents before July 29, 1999 you will have to manually terminate your private mortgage insurance once you reach 20% equity in your home, or 80% LTV or less. Be careful to pay special attention to this as the lender or bank is not required to notify you, and you will continue paying PMI if you fail to act.
There are many other specific statewide rules and rules for Fannie Mae and Freddie Mac loans, so always do your own due diligence, and contact your bank or lender to get all the facts for your specific loan in your particular state.
How can I avoid mortgage insurance altogether?
You can avoid paying private mortgage insurance altogether while putting no money down by utilizing a combo loan.
If you keep your first loan at 80% LTV or less, and add a second loan of 20% or less, you can still obtain 100% financing without paying PMI. Along with that, you’ll likely snag a lower blended mortgage rate by splitting the loan up. Learn more about mortgage combos and blended rates.
Or you can look into the Bank of America No Fee Mortgage, a so-called no cost loan that doesn’t require mortgage insurance, presumably even if the loan exceeds 80% loan-to-value. The TD Right Step mortgage also allows a three percent down payment with no mortgage insurance required. However, these programs typically have the mortgage insurance built into the interest rate, so it’s not really free.
Most homeowners these day opt for a second mortgage instead of doing one loan to avoid high interest rates and private mortgage insurance. The only real downside is the associated fees with a second mortgage, and the two separate payments.
Either way, you should always explore the possibility of two loans to determine which will be a cheaper alternative.
Tip: If you do happen to have a loan with mortgage insurance, you can always refinance out of it and drop the mortgage insurance if the new loan has an LTV of 80% or less. It’s not advisable to refinance just to get rid of mortgage insurance, but if you can snag a lower rate in the process, it could be a smart move.