If you’ve started researching the home buying process, you’ve likely come across the term “private mortgage insurance,” or, as it’s commonly referred to, PMI.
If you plan to take a conventional mortgage and don’t have 20% of the home’s purchase price to put down, you might be required to pay for PMI. Since PMI can have an impact on your monthly housing costs, you should understand what it is and why you might need to pay for it.
In this article, we will cover the basics of PMI. We’ll also discuss if makes sense to purchase a home with less than 20% down and pay for private mortgage insurance.
Some Mortgage-Related Background and Terminology
First, let’s define some basic home-buying and mortgage-related terms.
The “lender” (or mortgager) is the credit union or bank that is lending the money for the purchase of a home. The “borrower” (or mortgagee) is the homebuyer — the person borrowing money from the lender to buy the home.
The “mortgage” is the name for the loan that is taken out to buy a home. There are many types of mortgages available. Some, like FHA or VA home loans, are government-backed. Conventional mortgages are those available through and guaranteed by private lenders, like a credit union.
A “down payment” is the portion of the home’s purchase price that the borrower puts down when they buy the home (or “close” on the sale).
In this article, we’re discussing conventional mortgages. PMI usually only applies to conventional loans — government-backed loans have their own mortgage insurance requirements.
What Is PMI?
What is private mortgage insurance, anyway?
The Consumer Financial Protection Bureau defines PMI as “a type of mortgage insurance you might be required to pay for if you have a conventional loan. PMI is usually required when you have a conventional loan and make a down payment of less than 20 percent of the home’s purchase price.”
When you apply for a mortgage, you’re asking the bank to loan you a significant amount of money. Lenders understand there is risk in this. If you don’t have a large chunk of cash to put down at closing, the bank or lender is taking a larger risk by lending to you.
It’s a larger risk in the lender’s eyes for a couple of reasons. One, the buyer is starting out with a smaller financial stake in the home, making it theoretically easier for them to walk away if they find they can’t afford the mortgage payments anymore. Two, the more money that’s borrowed, the more the lender stands to lose if the buyer defaults (stops making payments) on the mortgage.
In other words, the borrower is compensating the lender for taking a risk on their behalf.
An important note is that PMI protects the lender, not the borrower — even though the borrower is the one paying for the insurance. However, PMI can benefit borrowers, too, in that it allows people to buy homes sooner than they otherwise would if 20% down was required.
How PMI Works
When you close on a mortgage, you put a portion of the home’s sale price down. As we mentioned, the traditional down payment for a conventional mortgage is 20% of the home’s purchase price.
With home prices rising, 20% of the purchase price can turn out to be a pretty good chunk of cash. For example, let’s say the Wisconsin median home price is $220,000. To put 20% down, you’d need to save $44,000. And that is on top of other expenses that you may encounter when buying a home, like inspection, appraisal, or origination fees.
That is not an insignificant amount of cash for most people. If a 20% down payment was a requirement, homeownership would remain out of reach for many families.
Enter PMI. Many lenders will finance mortgages for buyers that don’t have 20% to put down, provided the borrower has good credit, a stable source of income, and a comfortable debt-to-income ratio.
But, to minimize their own risk, the lender will require the borrower to pay PMI until they reach 20% – 22% “equity,” which is essentially the percentage of the home that the borrower truly owns.
When Can You Stop Paying PMI?
Luckily, PMI doesn’t last forever.
Once the borrower hits 22% home equity, the federal Homeowners Protection Act mandates cancellation, provided the borrower is up-to-date on payments. Many borrowers can get the PMI removed when they have 20% equity, but they will need to be proactive and contact their lender to request removal.
To help you calculate equity, divide the current loan balance by the current appraised home value. For example, if you have a mortgage balance of $195,000 and your home appraises for $250,000, you have a loan-to-value ratio of 78% (195,000 ÷ 250,000 = 0.78), and equity in the amount of 22% (100 – 78 = 22).
In other words, you’ve paid off 22% of the mortgage, you have 78% of the mortgage left to pay the lender, and you own 22% of the home.
Should You Buy with Less than 20% Down and Pay PMI?
There isn’t one right answer to the question of whether paying PMI is a good idea. A handful of variables influence whether it makes sense for your specific situation.
First, take a realistic look at your financial situation. The cost of owning a home goes beyond the monthly mortgage payments. Homes need routine maintenance and repairs (which can be costly). You’ll also pay homeowners’ insurance, property taxes, and utilities. PMI premiums can run anywhere from 0.25 – 2.0% of the home’s purchase price, so you’ll need to account for that when calculating how much cash you have to spend on housing each month.
You’ll also want to consider your credit score, income, and debt. If you have poor credit, unstable income, or a lot of debt, it’s smart to tackle those issues before applying for a mortgage. You’ll get a better interest rate and increase the chances that you will comfortably afford your home in the long term. Plus, the actual cost of PMI varies based on your income and credit, so that’s another reason to clean up your financial situation first.
However, if you have a stable job, good credit, and know you can afford the “extras” that come along with homeownership, it can certainly be worth it to buy sooner than later and pay for PMI.
One of the biggest factors in the decision to pay PMI is the current mortgage rates.
If you wait to buy until you have 20% to put down and end up with a much higher rate, you could pay more in interest over the life of the loan than you would in PMI premiums if you bought now and locked in a low rate.
If you can comfortably afford the mortgage, PMI, and other home-related expenditures, it’s smart to consider buying when rates are low.
The Bottom Line
As you now know, there are plenty of factors to consider as you decide whether you’re willing to pay PMI. It’s important to crunch the numbers and determine if buying with less than 20% down is smart for your specific situation.
The bottom line: if mortgage rates are reasonable and you know that you can comfortably afford a mortgage, PMI, and associated costs, it’s worth consideration.
If you are concerned about the costs, or if you have a poor credit score and/or lots of debt, it may be smarter to hold off until you’ve improved your financial situation and saved more cash.
Luckily for you, Connexus has a dedicated team of Mortgage Loan experts who are happy to walk through your specific financial situation and provide guidance. Schedule a chat now or give us a call and find out if you’re ready for homeownership.