If you’re trying to buy a house, you’ve likely been focusing on the two most-recognizable inputs that influence your monthly mortgage payment: principal and interest. Perhaps you’ve also been crunching the numbers on how much you’ll have to pay to protect the house once you get to call yourself the owner. However, while homeowners insurance will cover your interests, you may need to also pay for private mortgage insurance, or PMI, to cover your lender’s interests.
Read on for a comprehensive introduction to PMI -- when you need it, how much it might cost you, the different types of payment options and when you can stop budgeting for those monthly premiums.
What is PMI?
PMI stands for private mortgage insurance, and this is a type of insurance that protects the lender that’s helping you come up with the cash to buy a home. Why would the lender need insurance? Because there’s a chance that you won’t be able to pay back the loan, and if you’re making a relatively small down payment of anything less than 20% of the purchase price then you represent a greater risk on the lender’s books. It’s another way for the lender to protect itself against the worst-case scenario of default on the loan.
Don’t worry, you don’t have to pay PMI forever. Lenders will stop charging PMI premiums once you’ve accumulated 22% of equity in your home. It’s not because they’re nice, rather because it’s required by the Homeowners Protection Act. If, for example, your home is valued at $400,000, and the outstanding balance on your mortgage principal hits $312,000 -- meaning you’ve paid $88,000 of your principal -- then you no longer have to pay PMI.
How much does PMI cost?
The cost of private mortgage insurance varies, but there’s a simple rule: The less money you put down, the more you’ll pay in PMI premiums. Freddie Mac, for example, estimates that the typical borrower should expect to budget somewhere between $30 and $70 per month per $100,000. So, if you borrow $300,000, your PMI might add somewhere between $90 to $210 to your monthly payment.
An example of PMI
Consider this hypothetical breakdown from Freddie Mac’s PMI calculator, based on a home valued at $350,000 with a 30-year mortgage at 7% interest:
- 5% down: $319 per month
- 10% down: $205 per month
- 15% down: $83 per month
What factors determine your PMI?
If you’re trying to get a sense of how much you may wind up paying for PMI, it’s important to understand these three key factors.
Your loan-to-value (LTV) ratio: Commonly known simply as LTV, your initial loan-to-value ratio is based on your down payment. Simply put, lenders appreciate seeing a borrower who can put more money down upfront because it’s less risky to them. The higher your LTV, the more money you’ll pay for PMI. For example, a 97% LTV indicates that you’re only putting down 3% of the purchase price, which means you’ll pay a fairly high PMI premium.
Your credit score: Just as it’ll play a huge role in determining the interest rate a lender will offer you, your credit score will also play a big influence in your PMI. For example, the Industrial Federal Credit Union shows that someone with excellent credit of 740 or higher might have a PMI payment of just 0.2% to 0.3% of the total loan. A borrower with fair credit -- 620 to 660 -- might wind up with a premium of 0.75% to 1.5% of the loan. On a $300,000 loan, that can be as low as $600 and as high as $4,500 per year.
Your loan type: Lenders look at a fixed-rate mortgage a bit differently than an adjustable-rate mortgage, or ARM. With an ARM, your payment could wind up being higher after the introductory period -- which can spell trouble for your overall budget and ability to make ends meet. With that in mind, don’t be surprised if the PMI on an ARM is a bit higher to compensate for the heightened risk. Additionally, there are certain loans that don’t charge PMI, such as VA and USDA loans.
Is it worth it to consider a loan that charges PMI?
If you’re taking out a conventional loan and can’t afford to make a down payment of 20% of the purchase price, you’ll likely pay for private mortgage insurance. While no one likes paying additional fees, the trade-off is that you can start building equity much earlier instead of delaying your purchase while trying to save up for that magic 20% down payment (which can feel nearly impossible in many housing markets).
Let’s say, for example, you’re paying $2,000 a month in rent. If you keep paying rent, that’s $2,000 every month that goes to your landlord. Sure, you get a roof over your head, but you’re not reaping any of the benefits of actually owning the place. If you buy a home for $300,000 and put down 10%, you’ll need to pay for private mortgage insurance, but you’ll immediately start chipping away at the principal.
For example, a $270,000 loan at 7% interest creates a monthly payment of $1,796 for principal and interest -- $221 of which goes toward the principal. Freddie Mac’s calculator shows that your PMI payment would be around $176 per month. So you’re coming out ahead: You’ll build equity, and you’ll get to eliminate PMI once you have 20% equity in the property.
It’s also important to understand that you don’t have to do all the work to hit that 20% equity marker. If your home’s value increases due to a hot housing market (which has happened in many places throughout the country in recent years), you can get the home appraised to determine your equity level. For example, you might have purchased the home for $300,000 with that 10% down payment. Three years later, the home’s fair market value has appreciated to $350,000. That’s enough of an increase to help you automatically qualify to eliminate your PMI.
What are the different types of PMI?
Borrower-paid PMI: The most common approach to private mortgage insurance is borrower-paid PMI, which simply bundles the insurance premium into your monthly payment. So, in addition to paying the cost of your P&I payment, along with homeowners insurance and property taxes, you’ll include the PMI every month too.
Lender-paid PMI: With lender-paid PMI, the lender covers the costs of your premiums. The company isn’t doing this out of the goodness of its heart, though. You’ll wind up paying a higher interest rate and/or extra fees in your closing costs. This ultimately isn’t a great deal.
Single-premium PMI: A single-premium PMI payment is exactly what it sounds like: One lump sum instead of monthly recurring charges. Based on the math from some mortgage insurance providers, this approach can wind up saving you a lot of cash. Keep in mind, though, that you will need to have more money at closing.
Split-premium PMI: This is a balance between borrower-paid PMI and a single-premium PMI. For example, you might decide to commit an additional $3,000 at closing toward your PMI costs, which then shrinks your monthly fee.
FHA mortgage insurance: If you take out an FHA loan to buy your home, you’ll also pay mortgage insurance. However, it’s not technically private mortgage insurance, and it works a bit differently than the insurance attached to conventional loans. You’ll pay an upfront premium of 1.75% of the loan amount, followed by annual mortgage insurance premiums. The FHA annual mortgage insurance costs were recently lowered (it’s now 0.55% for most FHA borrowers), but it’s not all good news: If you make a down payment of less than 10% on an FHA loan, the only way to get rid of these premiums is to refinance your mortgage.
How to pay for PMI
The easiest way to pay for PMI is to bundle the premium into your monthly payment. There’s no real work involved on your end. In this case, the money is automatically paid out to the insurance provider. You can also ask your lender about paying the premium upfront each year. This will create some additional room in your monthly budget, but you’ll need to have enough money set aside for the one-time payment.
How can you reduce or avoid paying PMI?
There are two common types of loans that don’t charge PMI: VA and USDA loans. However, not everyone can qualify for these kinds of mortgages. If you don’t meet the eligibility requirements, here are a few options to consider:
Shop around: There are some lenders that offer special no-PMI loans to attract borrowers. These are fairly rare, but they’re out there. For example, the Credit Union of Texas offers a 5% down with no PMI program. Don’t let the no-PMI disclaimer be the ultimate selling point, though. Make sure you compare traditional programs that charge PMI to make sure you’re actually getting a better deal.
Use a piggyback mortgage: There are lenders that will help you create a workaround that eliminates PMI via what’s known as a piggyback mortgage. With this arrangement, you’ll get a loan that covers 80% of the purchase price, along with another loan that covers 10% or 15% of the purchase price while only contributing 5% or 10% of the purchase price with your own money. The upside: no PMI. The downside: a somewhat convoluted system of two different monthly payments.