What Is PMI? (And Why You Want to Avoid It)
PMI is private mortgage insurance. It’s often required by conventional mortgage lenders to finance loans for individuals who do not have the traditional down payment of (at least) 20 percent. It’s a helpful way to purchase a home with a smaller down payment, but it’s also an expensive option.
Rates vary but typically range between .3 and 1.5 percent of the loan amount on an annual basis. For example, if the total amount borrowed is $250,000, a 1 percent PMI rate costs $2,500 per year, or slightly over $208 per month. That’s on top of other expenses, like mortgage principal and interest, taxes, and property insurance.
Similar to the interest on your loan, PMI is money that flows out each month but doesn’t build any equity in the house. It is insurance on the loan for the other party…the lender. It’s required because, with less than 20 percent down, you are considered a higher risk to default on the loan.
A Different Approach
Instead of buying a house now and paying PMI, consider setting up an investment account and funding it each month with what you WOULD have paid in PMI, plus the interest on your mortgage.
Using the same $250,000 example above and a mortgage interest rate of 4.66 percent, the monthly savings goal would be $1,156 ($208 in hypothetical PMI expense plus $948 in monthly interest on a 30-year mortgage). In three short years, you’d save more than $40,000!
Combined with your original savings for a down payment, this may be more than enough to reach the 20 percent threshold for PMI.
In addition to avoiding PMI, you’d also reduce your overall interest cost by thousands of dollars (by borrowing less). Additionally, this approach puts you in a better position to negotiate a favorable interest rate on your mortgage, another way to save thousands of dollars of interest expense over the life of the loan.
If you aren’t willing to wait or need to buy a house with less than 20 percent down, it’s important to understand that PMI is paid by the borrower, but the lender is the sole beneficiary of the insurance policy. Also, your PMI payments are not a tax-deductible expense.
Can you cancel PMI once you have enough equity in the home to cross the 20 percent threshold? Yes, but in most cases, this doesn’t happen automatically.
Some lenders make you jump through hoops to remove PMI from your loan, requiring a formal letter requesting the insurance be canceled. Some require a new appraisal to make sure your equity in the home represents 20 percent of the current value of the house. If your home has depreciated in value, you’ll probably be required to continue paying PMI.
Some lenders require buyers to carry PMI insurance for a designated number of years, even if the 20 percent equity threshold has been met and/or exceeded.
These are all important points to ask lenders when shopping for a mortgage. Take time to get familiar with real estate terminology and be sure to read all the fine print when you are closing on your house, including the PMI documents. Your Accredited Buyer’s Representative is also a valuable resource for answering any questions you may have throughout the home buying process.