Why Do I Need to Pay Private Mortgage Insurance?
Private mortgage insurance (PMI) is also known in different parts of the country as mortgage insurance, mortgage protection insurance (MPI), and Mortgage Insurance Protection (MIP).
Think of the down payment as a gesture of good faith--the bigger the down payment, the more you prove to the lender that you have the ability to pay back your mortgage. This is why, traditionally, people always put down 20 percent of the home's purchase price.
Whatever you call it, when you're buying a home and have less than a 20 percent down payment to put on a house, you are required to pay for private mortgage insurance. Generally, the larger the loan amount, the more risky it is to the lender. Private mortgage insurance is protection for the lender against a borrower defaulting on the loan. If the borrower can't pay back the loan, the lender has a way to get its money back.
Private Mortgage Insurance Can Be Expensive
According to the Mortgage Bankers Association of America (MBAA), private mortgage insurance is usually about one-half of one percent of the loan amount. So let's say you're buying a house that costs $150,000 and your down payment is $7,500 (or 5% of $150,000). Your loan amount then, is $142,500. The amount of annual PMI you'd have to pay is $712.50. That comes to nearly another $60 a month to have to pay along with your mortgage payment. For many people, this can be pretty costly. If you think about it, $60 could pay between one and two tanks of gas, depending on what kind of vehicle you own.
Fortunately, the Homeowners Protection Act of 1998 allows you to discontinue private mortgage insurance when you've reached 20 percent equity in the home (meaning you've paid off 20 percent of the principal loan balance). If you haven't proactively called your lender to cancel PMI, the law also requires lenders to automatically discontinue it when you've reached 22 percent equity.
However, there are ways you can avoid paying PMI altogether.
How to Avoid Paying Private Mortgage Insurance
There are two ways to get out of paying costly private mortgage insurance. One way is to agree to a higher interest rate. If you're paying a higher interest rate, the loan is considered less risky to the lender and the lender will waive the PMI requirement. The benefit to you is that mortgage interest is tax-deductible* whereas private mortgage insurance is not.
The other way to avoid paying PMI is to get a "piggyback" loan. A piggyback is when you get a first and second mortgage at the same time or within a few days of each other. So, if you didn't have any money for a down payment, you'd get an 80-20 where the first number represents the first mortgage (80 percent of the loan amount) and the second number represents the second mortgage (the remaining 20 percent of the loan amount). If you had a five percent down payment (as in our previous example), you'd get an 80-15-5 where the 80 represents your first mortgage; the 15 represents the second mortgage; and the 5 represents the percentage amount of your down payment. It's possible to have other permutations of this as well, such as 80-10-10. The second loan will have a higher interest rate, but the monthly payments on the first and second loan will still equal less than paying one loan with PMI.
Getting a mortgage has to fit your situation and your circumstances. You may have to get a mortgage that requires paying PMI. If that's the case, you can cancel PMI after you've reached 20 percent equity in your home. But if it's at all possible, try to choose a loan that doesn't require having to pay costly private mortgage insurance. Your wallet will thank you.
*Please consult your tax advisor.
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