I’m sure most prospective homeowners like the idea of putting little to nothing down when purchasing real estate, 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, not to mention a higher loan balance.
Aside from having a larger mortgage payment, and a higher mortgage rate, you might also be hit with an extra form of insurance to offset the risk you present to the lender.
It’s known as “private mortgage insurance,” or PMI for short. Let’s talk about what it is, and more importantly, how you can avoid PMI!
What is private mortgage insurance?
- PMI is coverage that protects the bank/lender from borrower default
- It is NOT protection for the homeowner (but you have to pay for it!)
- Safeguards the lender in the event you’re unable to pay your home loan
- Allows them to offer low-down payment mortgages that are historically more risky
In short, mortgage insurance is all about risk and protection. Simply put, 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 probably still sell the home for a profit if it falls into foreclosure.
If it’s a no-down payment mortgage and home prices take a dive, it could turn into an underwater mortgage, which would equate to a big loss for the lender when they attempt to offload it.
That’s where private mortgage insurance comes in. Lenders are willing to dole out low- or no-down payment loans, but they want assurances they won’t lose their shirt in the process.
PMI solves this dilemma by protecting the originating bank or lender when a borrower with a very high loan-to-value mortgage defaults. By protects, I mean insures. Lenders aren’t taking their chances here.
That’s right, PMI is for the lender’s protection, not yours. And YOU pay for it, not them.
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.
However, it is also said to benefit borrowers by giving them the opportunity 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 these days can obtain 97% LTV financing (3% down) or higher if they agree to pay private mortgage insurance, thereby avoiding the need for a large down payment.
The trade-off is they get the house they want now, even if they don’t have the traditional 20% down payment.
When is mortgage insurance required?
- Generally required if you put down less than 20% on a home purchase
- Or if you lack 20% home equity for a mortgage refinance
- Not all banks and mortgage lenders explicitly charge it (some waive it or build it into your interest rate)
- It is required for all FHA loans regardless of down payment or LTV
Borrowers who take out conventional loans (those not guaranteed by the government) and are unable or unwilling to come up with a 20% down payment must pay private mortgage insurance to obtain a mortgage.
This is similar to the mortgage insurance premium (MIP) paid by borrowers on FHA loans, though PMI is referred to as private because it doesn’t involve a government loan.
Rather, it tends to involve loans backed by Fannie Mae and Freddie Mac (conventional mortgages) and a private mortgage insurance company.
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%, or that they don’t charge it.
But it’s likely just factored into the (higher) interest rate you receive. So you’re still paying for private mortgage insurance in these cases, just not directly.
To give you an example, if your mortgage rate were 4%, and you’re told you can avoid PMI at a rate of 4.25%, it’s still being paid for by you. But via higher monthly mortgage payments instead.
What mortgages don’t require PMI?
- VA loans (but they have an upfront funding fee)
- FHA loans (but they have their own monthly mortgage insurance premiums known as MIP)
- Conventional loans with at least 20% down payment (truly avoid PMI)
- Conforming loans backed by Fannie/Freddie with at least 20% down payment (truly avoid PMI)
- Portfolio loans where the lender doesn’t charge it (but could result in higher mortgage rate)
- Loans with lender-paid mortgage insurance (results in higher mortgage rate or closing costs)
How much does private mortgage insurance cost?
- Just like mortgage interest rates it depends on your particular loan scenario
- More risk (higher LTV, lower credit score) results in a higher premium
- A combination of high risk factors will lead to the highest price
- Work with your bank or broker to shop PMI and/or run different scenarios to drive down the cost
The cost of private mortgage insurance can vary greatly and carries its own pricing adjustments, just as the associated home loan does.
In other words, your LTV, credit score, loan balance, the amount of coverage, transaction type (cash-out refinance , rate and term refinance, purchase), loan type , loan-to-value ratio, and premium type can all come into play.
The greater the combined risk factors, the higher the cost of PMI, similar to how a mortgage rate increases 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.
The type of mortgage insurance also matters, such as borrower-paid versus lender-paid, along with annual premiums vs. single premiums, refundable vs. non-refundable, and so on.
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 PMI cost example:
Purchase price: $200,000
Loan amount: $190,000
Loan-to-value ratio (LTV): 95%
Mortgage insurance premium: 0.70% of loan amount (paid monthly)
In the scenario above, you’d be looking at a cost of $110.83 per month for PMI coverage, which is lumped on top of your monthly housing payment.
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. So if you want to buy real estate with little to nothing down, expect a higher PMI rate.
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)
- HOPA offers three options to remove PMI
- Automatic termination at 78% LTV
- Borrower-requested removal at 80% LTV
- Final termination at midpoint of loan term
I’m assuming the most popular question with regard to private mortgage insurance is how to cancel it? Fortunately, there are many ways to get rid of PMI.
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).
This is the case regardless of whether the property declined in value since the time of purchase.
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.
In the case of borrower requested removal, you may be required to pay for a home appraisal, especially if home prices have gone down since purchase, so bear that in mind.
Additionally, you may have to prove that the property isn’t encumbered with any subordinate liens, aka second mortgages, which lower the amount of available equity in the home.
Lastly, 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.
Canceling Mortgage Insurance on a Fannie Mae or Freddie Mac Loan
- Must pay MI for at least 2 years before requesting removal at 75% LTV or lower
- Must pay MI for at least 5 years before requesting removal at 80% LTV
- Exception if you made home improvements
- Must be borrower-initiated
- Must order an appraisal or BPO to assess current value
- Borrower must be current on mortgage payments
As mentioned, Fannie Mae and Freddie Mac have their own guidelines regarding mortgage insurance cancellation.
The biggie is that at least two years must have gone by since the origination date to execute a borrower-requested cancellation using the current value of the property (supported by an appraisal).
In other words, even if your property doubled in price over the course of 12 months, Fannie and Freddie wouldn’t let you cancel your MI. You’d have to wait until at least two years had passed.
Additionally, they’ll only cancel it if the LTV falls to 75% or less based on the current appraised value.
If you think your current LTV is at or just below 80%, there is a longer five-year seasoning requirement.
This means you must pay MI for a full five years, unless an appraisal proves your home appreciated enough to push the LTV down to 75% or less.
The one exception to these timelines is if you made improvements to the property.
In this case, Fannie will allow you to drop MI with no minimum seasoning requirement if the LTV is 80% or less.
For Freddie, the same LTV threshold of 80% or less applies.
In either case, you’ll need to prove you made some significant improvements to support the home’s value versus the original value.
This should entail something like a major kitchen or bathroom renovation, not just basic repairs or a fresh coat of paint. So be prepared to make your case.
Keep in mind that these guidelines apply to one-unit primary residences and second homes. There are different thresholds for 2-4 unit primary residences as well as 1-4 unit investment properties.
Lastly, you need to be current on the mortgage, which generally means no late payments whatsoever in the past 12 months, and no payment 60 days or more past due in the prior 24-month period.
How can I avoid mortgage insurance altogether?
- It’s actually very simple to avoid PMI
- Don’t take out an FHA loan (go conventional/conforming instead)
- And put down at least 20% when purchasing a property
- Or have 20%+ equity when refinancing an existing home loan
Yes! It’s pretty simple, really. Just put down 20% or more when you buy a home, or don’t borrow more than 80% of your home’s value when you refinance (20% equity position).
There’s nothing more to it. You won’t have to pay PMI!
But if that’s not an option for you, as it isn’t for most, it’s still possible to avoid paying private mortgage insurance altogether while putting no money down thanks to a combo loan.
Here’s how it works. If you keep your first mortgage at 80% LTV, and add a second mortgage of 20%, you can still obtain 100% financing without paying PMI.
The first lender doesn’t care as long as their loan stays at or below the key 80% LTV threshold.
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 certain loan products like 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.
Is the mortgage insurance built into the rate? What about a second mortgage?
As mentioned, these programs sound good on the surface, but a word of caution.
They typically just have the mortgage insurance built into the interest rate. So it’s not really free. It’s just not directly paid out of pocket.
And worse, that means it stays with you for as long as you hold the mortgage.
It used to be common for homeowners to opt for a second mortgage instead of taking out one loan to avoid high interest rates and private mortgage insurance.
The only real downsides were the associated closing costs with a second mortgage, and the two separate payments you had to keep track of.
Nowadays, more borrowers seem to be going with one loan at a higher LTV, which is fine too as long as the mortgage insurance rate is reasonable, and doesn’t make your home loan unaffordable.
Either way, you should always explore the possibility of two loans to determine which will be a cheaper alternative. There are loan calculators out there (including my own) that will do the math for you.
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 amount has an LTV of 80% or less.
It’s not always advisable to refinance just to get rid of mortgage insurance, but if you can snag a lower interest rate in the process, it could be a really smart move if you’re into saving money.
In fact, an FHA-to-conventional refinance is a common tactic FHA borrowers employ to get rid of the mortgage insurance most of them would otherwise have to pay for the life of the loan.