What is PMI, anyway?
Homebuying is a study of acronyms. There's FHA (Federal Housing Administration), APR (annual percentage rate), DTI (debt-to-income ratio), EMD (earnest money deposit), LTV (loan to value ratio), to name a few—plus, it all might cost you an ARM (adjustable mortgage rate) and a LEG (OK, there's not really an acronym for that last one). And while it's not a four-letter word, there’s a certain three-letter acronym that’s both maligned and misunderstood: PMI, or private mortgage insurance.
Keep reading for TMI on PMI: learn what it is, how to avoid it, and how to make it work if there's simply no way around it in your homebuying journey.
What is PMI?
PMI is the real estate industry acronym for private mortgage insurance. According to legal website NOLO, this type of insurance is designed to reimburse a mortgage lender if the buyer defaults on the loan and the foreclosure sale price is less than the amount owed by the lender.
How does it work?
If you make a down payment of 20 percent or more, you will not be charged any PMI. If you can’t put a full 20 percent down payment on a home, lenders require you to pay monthly private mortgage insurance until you’ve paid the total loan balance down to 80 percent or have a loan to value ratio of 80 percent. At this point, you’re eligible to ask your lender to cancel PMI (part of the Homeowner’s Protection Act of 1998). Once your loan balance reaches 78 percent, PMI will automatically drop off of your monthly payment.
Still confused? Let me offer you a case study.
Let’s say you can’t afford to put the standard 20 percent down on your house (amassing a down payment is one of the biggest obstacles to home ownership, resulting in some loans requiring as little as 3.5 percent down). Instead, you put 10 percent down on your home. That means your balance is 90 percent, and you can expect to pay PMI for several years until that balance drops to 80 percent (or 78 percent for an automatic PMI removal).
From then on, you’ll notice a lower monthly mortgage payment as you’ve sufficiently reached 20 percent or more equity in your home. Paying off PMI typically takes about five years, and you’re usually required by lenders to keep it for two years even if you reach 20 percent equity before then.
How much does it cost?
In short: a lot. Most PMI fees cost between 0.5 and 1 percent of the loan amount per year. Lenders calculate how much PMI costs by using tables that factor in things like the loan to value ratio (more on that later).
But for a simple example, let's say you borrowed $300,000 and opted for a very low down payment. In that case, a lender's PMI table would probably require you to pay the full 1 percent, meaning you would be paying up to $3,000 per year for private mortgage insurance. Split up monthly, that means an extra $250 for your mortgage payment.
The duration for which you'll pay PMI will depend on how much money you put down initially, how long it takes you to get 20 to 25 percent equity in the house, or how long until you can achieve a lower loan to value ratio (more on that below). Typically, the lender will require you to pay PMI for at least two years, and it can sometimes take more like five to seven years to achieve the amount of equity you need—for $300,000, PMI will cost you at least $6,000 over two years, and could cost as much as $21,000 if it takes longer for your to achieve a balance of 80 percent of the loan.
How can I avoid it?
Currently, the only way to avoid PMI is to put the full 20 percent down. As mentioned, this is hard to do for many people up front.
How can I get rid of it?
If you can't avoid PMI, you can take a few steps toward removing it from your monthly mortgage payment:
- Pay just a little bit more each month. Even tacking on $50-$100 monthly can bring your loan balance down significantly.
- Keep an eye on your loan to value ratio. That’s calculated simply by dividing the mortgage amount by the appraised value of your home. If you live in a hot neighborhood, you might see the value of your house go up over time. That means your accompanying loan to value ratio would go down, potentially bringing you closer to the 80 percent sweet spot where you can ask your lender to cancel PMI. (Remember, once your loan balance hits 78 percent, PMI will drop off automatically without you having to write to your lender).
- Consider renovating. Although this will cost you more money, smart renovations can increase the value of your home and lower your loan to value ratio. You'll still need an official appraisal, though, which brings me to...
- Get your house reappraised. If you've noticed property values have gone up or you've renovated your home or added square footage, you can have a formal appraisal to see if you've achieved the 20 percent equity threshold. Word to the wise, though—appraisals usually cost about $500, paid up front.
- One more thing: If the value of your home goes up, you'll be paying more in taxes. Isn't home ownership fun? However, your city or county tax appraisal office will not see your private appraisal, nor will it be part of their consideration for tax rates.