What is Private Mortgage Insurance (PMI)?
Private mortgage insurance is an add-on to a mortgage that is required if a buyer plans to purchase a property with less than 20% down. With a down payment of less than 20% (the typical rule-of-thumb amount) the lender is carrying a much higher risk of the buyer defaulting on the loan. In order to protect themselves, lenders add a PMI premium onto the loan. It is important to note that on almost all government-backed loans (conventional, FHA, USDA, and VA loans that are sold to Fannie Mae and Freddie Mac), there will be a PMI premium. For more information about these types of loans, read this article.
For first-time home buyers, saving up for a 20% down payment can take a very long time. Conversely, a down payment as low as 3% takes much less time to save. For just a little extra in payments every month, new first-time home buyers can buy a home many years sooner.
What does PMI cost?
Private mortgage insurance ranges from 0.5%-2.5% of the purchase price annually. The amount the borrower pays varies depending on their credit score, down payment amount, and the price of the property. As a buyer, you will know in advance of closing what the PMI amount will be, which will allow you to budget and plan for payments.
The PMI payments are commonly rolled into your monthly mortgage payments. Another common method of making the PMI payments is to pay the yearly PMI amount as a lump sum at the beginning of the year. This method is cheaper overall, but may not be financially feasible for all borrowers. Speak to your lender about which payment method is preferred and right for you.
Drawbacks of PMI
- Costly – This is obvious because it is an extra insurance payment on top of the mortgage. Extra budget planning and/or saving may be necessary to help with the extra cost.
- Not tax deductible – Under the new tax laws that went onto effect in 2018, you can no longer deduct PMI payments on your taxes every year.
- Difficult to cancel/remove – Under FHA loan rules, PMI will stay until the loan is paid off. In order to remove the PMI, you need to refinance. That is a whole process in itself that is time-consuming and takes some planning.
- If you have a conventional loan, the PMI will go away when you reach 20% loan-to-value (LTV). LTV is the ratio of the loan amount to the value of the home. This can take up to 7-10 years on average.