If you look at your monthly mortgage statement and see a line for “PMI,” you’re paying for private mortgage insurance. It probably costs you between $50 and $200 per month, depending on the balance of your loan and your PMI rate.
But why are you paying it? Essentially, your lender is requiring you to pay the premiums for an insurance policy that partially reimburses them should you default on your mortgage. We’ll discuss when you’re required to have PMI, what this insurance protects, who needs to carry it, and ways to avoid paying it.
Loan to Value (LTV) Ratio
The loan to value (LTV) ratio is what the lender looks at to determine whether or not you need to pay PMI, and when you can stop paying it. To calculate this ratio, take the amount of the loan and compare it to the current value of your house. For example, if your mortgage is $150,000 and your home is currently worth $200,000, your loan to value ratio is 75%.
When you buy a new home, your lender will look at the amount of your down payment compared to the sales price to determine your loan to value ratio. So if you purchase a home for $200,000 and put $20,000 down, your loan to value ratio is 90%. Typically, if your loan to value ratio is more than 80%, you’ll be required to pay PMI.
What Is Private Mortgage Insurance?
When you apply for a mortgage, the lender wants to make sure your home will have enough equity to pay off the loan balance should you default and go into foreclosure. But since foreclosed upon homes are often sold at a “discount,” lenders want a buffer of at least 20%. In other words, they want to be reasonably sure they can recoup the money they loaned you if the home has to be sold at a lower price than the original sales price.
However, this doesn’t mean that lenders are unwilling to write loans when you put down less than 20%. They just charge you more for the privilege via PMI. In this way, you get a mortgage, and they minimize their risk in offering you a loan. Private mortgage insurance is an actual insurance policy issued by an insurance company that benefits your lender. If your home goes into foreclosure and the lender is not able to recoup the outstanding balance by selling the home, the insurance company that issued your PMI will pay the lender the difference.
PMI is called “private” because it is only offered to private companies and not government agencies or public mortgage lenders. Public programs, such as the FHA and VA mortgage programs, have their own mortgage insurance, but it is run differently and managed internally. However, one notable difference between PMI and mortgage insurance attached to many FHA and VA loans is that the latter never expires. In other words, you will continue paying mortgage insurance on FHA and VA loans even after your loan to value ratio has dropped below 80%.
Who Needs Private Mortgage Insurance?
Generally, if your LTV ratio is less than 80%, you’re in the clear. However, if you have poor credit or are otherwise considered a high risk to the lender, you may be required to carry PMI even if you have a 70%, 60%, or even 50% loan to value ratio.
You may be considered “high-risk” if you’ve sold multiple homes recently, have been foreclosed upon, or if you have an unsteady or undocumented income. However, this should be clearly laid out in your loan documents, and if you aren’t sure how it works, get a clear answer from your loan officer before signing.
How to Avoid Paying Private Mortgage Insurance
The best way to avoid paying PMI is to not have it on the loan to begin with! If you are purchasing a new home, but won’t have a significant down payment, ask your loan officer for suggestions on avoiding PMI.
In the past, a popular option was the 80-10-10 or piggyback mortgage, which used a combination of a second mortgage or home equity loan and your down payment to reduce the loan to value ratio of the primary mortgage. This may still be available through some lenders today.
But if you are already in a mortgage that has PMI, you have two options to remove it:
1. Meet the Loan to Value Ratio
If your loan is near the 80% threshold or whatever threshold your lender stipulated in the initial mortgage paperwork, PMI will be automatically removed by the lender. In practice, most lenders wait until 78%, but if you call and ask, they will remove it sooner.
Since your lender will calculate LTV off the original purchase price, you’ll need to keep track of your home’s current market value. In other words, if your home has increased in value, you can obtain a professional appraisal and present this to the lender as proof that the value has increased.
While professional appraisals usually cost a few hundred dollars, this can be money well spent if it gets you out of paying PMI several months or years earlier than you otherwise would have.
2. Refinance the Mortgage
Before you refinance a mortgage, weigh the expense against the monthly savings. Also make sure you’re comparing apples to apples. In other words, if you have 25 years left on your current loan, request lender quotes for a 25-year mortgage on your current loan balance amount and see how the numbers add up.
If your current loan requires PMI and a new one would not, and if you also qualify for a lower interest rate, a refinance will probably make sense. For example, let’s say your current loan requires a loan to value ratio of 70% before you can stop paying PMI and your current loan to value ratio is 75%.
If your credit has improved since you applied for the original mortgage, you may be able to refinance into a new mortgage where the threshold for PMI is 80%. This means you wouldn’t have to pay PMI with the new mortgage.
But to determine if this refinance actually saves you money, look at how long it takes to recoup your closing costs via your monthly savings, and make sure you’ll be in the house that long. Again, and this can’t be overstated, make sure you’re comparing apples to apples when reviewing lender quotes: the new loan term and balance need to be the same as what’s on your current mortgage.
Paying private mortgage insurance is often a necessary cost if you want to purchase a home without a significant down payment. However, you need to understand the terms of your current mortgage contract and calculate your loan to value ratio to avoid paying it longer than absolutely necessary.
Moreover, knowing when and how to remove PMI will lower your monthly mortgage bill. Follow the tips above and the next time you apply for a mortgage, make sure you understand the PMI rules and ask for clarification before signing.
Are you paying private mortgage insurance? What are some of the steps you’re taking to remove it from your mortgage loan?
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