Private Mortgage Insurance (PMI) & How to Avoid It
What is PMI? PMI stands for private mortgage insurance. Private mortgage insurance protects lenders from losses they may incur due to the dreaded double whammy of default and foreclosure. Uncle Sam provides the mortgage insurance on government loans (FHA, VA, USDA, and FmHA). Private insurance companies provide private mortgage insurance (PMI) on all other loans.
Who pays for this insurance? You, of course — if you want a conventional loan and can’t make at least a 20 percent cash down payment on the property you’re buying or refinancing.
“Wait a second,” you say. “That seems incredibly inequitable, even for lenders. I pay for the insurance, but my lender gets the proceeds? What’s in it for me?” A loan. It’s the only way to get conventional financing with a low cash down payment. That’s the deal. Take it or leave.
Twenty percent is a magic number to institutional lenders. They made a fascinating empirical discovery after suffering through years of expensive, unpleasant experiences with belly-flopped loans. At least a 20 percent down payment is necessary to protect their investment (the mortgage) if you cut and run on your loan.
Look at things from their perspective. Suppose that you put only 10 percent cash down. A severe recession occurs, and property values drop 15 percent. You lose your job because your business fails, and you can’t make your monthly loan payments. The lender is forced to take your house away from you in a foreclosure action and sell it to satisfy your debt. Farfetched? Hardly. Read your local paper. Stranger things happen every day. Witness the jump in foreclosures in most areas in the years just before and after the 2008 financial crisis and recession.
After the poor, misunderstood lender involuntarily takes back your now vacant home, fixes it up to make it marketable, and pays the real estate commission, property transfer tax, and other customary expenses associated with the sale of your house, there won’t be nearly enough money left to pay off your loan. Your lender will lose his corporate shirt. If that scenario happens too often, the lender goes belly up.
You may be able to deduct your PMI premiums on your federal tax return. For loans that commenced after 2006, borrowers with an adjusted gross income (AGI) of up to $100,000 may deduct their PMI premiums as they do mortgage interest on IRS Form 1040, Schedule A. The deduction is phased out in 10 percent increments for each $1,000 in increased income above $100,000. Above $109,000, PMI isn’t tax deductible.
What you’ll end up spending for PMI depends on the following factors:
- Type of loan: For example, adjustable rate mortgages generally have higher PMI premiums than fixed rate mortgages.
- Loan amount: Your PMI premium is partially based on a percentage of the loan amount — the more you borrow, the more you’ll pay for PMI.
- Loan-to-value (LTV) ratio: LTV ratio is the loan amount divided by the appraised value of the property you’re buying or refinancing. The higher the LTV ratio, the greater the risk of default to the lender and, hence, the higher your PMI premium.
- Credit Score: Your PMI premium is also partially based on your credit score.
- The insurance company issuing your PMI: This is the least important factor because PMI charges usually vary relatively little from one insurance provider to the next. It can’t hurt, however, to instruct your lender to shop around for the best deal.
Even though PMI charges don’t usually vary much from one insurer to the next, the type of loan they insure and geographical areas of coverage can vary wildly. The late 2000s mortgage market problems made lenders more cautious. Ditto PMI insurers. MGIC (Mortgage Guaranty Insurance Corporation, the largest private mortgage insurer), Radian Group, and Genworth Financial (two other large insurers) are now much more selective about loans they’ll insure.
Insurers are skittish now about property in distressed markets where values are declining and loans with less than 5 percent cash down. Your lender may have to shop around to find a PMI provider who’ll issue your policy.
PMI origination fees and monthly premiums change frequently. Check with your lender for specifics on PMI expenses for your loan.
PMI isn’t a permanent condition. You can discontinue it by proving you have at least 20 percent equity in your property. Equity is the difference between your home’s current market value and what you owe on it. The magic 20 percent can come from a variety of sources: an increase in property values; paying down your loan; improving the property by, for example, modernizing the kitchen or adding a second bathroom; or any combination of these factors.
You might be wondering how to avoid PMI. To remove PMI, your lender will no doubt insist that you have the property appraised (at your expense, of course) to establish its current market value. Spending a few hundred dollars for an appraisal that’ll save you hundreds or more a year in PMI expenses is a wise investment.