What is Private Mortgage Insurance?

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If you’re a first-time homebuyer, you’re probably going to hear something called mortgage insurance, often referred to as PMI. You’ll have to pay mortgage insurance premiums on most home loans if you make a down payment lower than 20% of the home purchase price.

Though you can’t shop around for PMI for a mortgage like you would for homeowner’s insurance, you do have options available to you. Some of the choices you make regarding a home loan will have a major impact on what you pay for Private Mortgage Insurance (PMI). It’s important to know what those options are and to have a basic understanding of mortgage insurance overall.

How does Private Mortgage Insurance work?

PMI stands for private mortgage insurance. It helps ensure that your lender will be able to recover its money in the event you or the borrower defaults on the loan and goes into foreclosure. It’s often charged on conventional loans, used for mortgages backed by Fannie Mae or Freddie Mac.

Mortgage lenders like to have a 20% down payment to provide themselves with enough financial cushion against default. That’s money in hand that can cover the cost of foreclosure and guard against the possibility that the home’s value may depreciate.

They’re sometimes willing to accept a lower down payment, but that represents a greater risk to the mortgage lender. They require private mortgage insurance to cover the difference between your down payment and the 20%. So if you put 5% down, your private mortgage insurance will pay the lender 15% of the home’s sale price in the event you default on the home mortgage.

So you pay the mortgage insurance premiums, but it’s the lender’s money who’s being insured. That might not seem fair, but the private mortgage insurance cost represents the added risk the mortgage lender is taking on with a smaller down payment – so you have to pay for it.

How much is Private Mortgage Insurance?

Mortgage insurance rates for PMI vary depending on a number of factors, primarily your credit score and the amount you put towards your down payment. For most mortgage borrowers, mortgage insurance premiums will be an annual fee 0.35-0.9% of your mortgage loan amount. Billed as part of your mortgage payments in equal monthly amounts.

Mortgage insurance premiums may be higher for high-value homes (jumbo loans), manufactured homes, cash-out refinancing, second homes, investment property, down payments less than 5%, and mortgage borrowers with poor credit.

FHA mortgage insurance is set up somewhat differently. With an FHA home loan, you pay an upfront mortgage insurance premium of 1.75% of the loan amount at the time of the loan. Then an annual fee that for most mortgage borrowers is 0.85% of the mortgage loan amount. Billed as a monthly charge on the mortgage statement. That amount can be as high as 1.05% on jumbo loans and as low as 0.45% on 15-year mortgages.

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PMI vs. FHA mortgage insurance

Aside from the different fee structures, there is some significant difference between PMI and FHA mortgage insurance. FHA mortgage insurance premiums are not tied to your credit score, for starters, unlike PMI mortgage insurance rates.

The big difference here is that it’s easier to cancel PMI once you acquire sufficient home equity. You can have your private mortgage insurance canceled once you reach 20% home equity. Either by paying down your loan or through an increase in property value (an appraisal may be required). Your mortgage lender also must cancel private mortgage insurance automatically when your mortgage loan amount falls to 78% of the purchase price through scheduled amortization; that is, making regular mortgage payments.

FHA mortgage insurance premiums cannot be canceled if you put less than 10% down on a 30-year mortgage. You have to carry them for the life of the loan. You can get around this by refinancing once you reach 20% equity, but that’s way more costly than simply being able to cancel it as you can with private mortgage insurance.

VA Loan mortgage insurance and USDA loans

Mortgage insurance is also required on a VA loan. Except that the U.S. government picks up the cost as a benefit to veterans, active-duty personnel, and others meeting eligibility requirements. That’s why those who qualify can get a VA loan with no money down.

The same is true for USDA Rural Development Loans, which are home loans for borrowers with low-to-moderate incomes who currently lack adequate housing. The government insures the loan, so no down payment is required.

Is Private Mortgage Insurance tax-deductible?

Historically, PMI and FHA mortgage insurance have not been tax-deductible. Still, Congress passed legislation in 2007 making both deductibles for new home purchase loans beginning that year (refinances and pre-2007 mortgages are not eligible). That legislation has expired several times, but Congress has stepped in and extended it retroactively, most recently through 2016. But it’s not clear if Congress will continue to do so, so check the current status before filing your taxes.

About lender-paid mortgage insurance

A variation on private mortgage insurance is lender-paid mortgage insurance. In this case, the lender self-insures the loan by charging you a higher mortgage loan rate. Usually a .25% to .5%, rather than having you or the borrower pay mortgage insurance premiums.

The big advantage of lender-paid mortgage insurance is that it is tax-deductible since the cost is part of your mortgage loan rate. You don’t have to worry about Congress extending it. The downside is that you can’t cancel it once you reach 20% equity. It’s a permanent requirement of your loan that you can only get rid of by refinancing. However, it can be an attractive option for borrowers who expect to move again within a few years.

In some cases, lenders will charge lender-paid mortgage insurance as a single fee at closing. In this case, you don’t get the tax deduction because it’s not part of your mortgage rate.

Using a piggyback loan to avoid PMI

You can sometimes avoid paying for private mortgage insurance or FHA mortgage insurance by using a piggyback loan. The second mortgage loan is used to cover the difference between your down payment and 20%, so you don’t have to pay mortgage insurance premiums on the initial loan.

Let’s say you put 5% down, and you might take out a piggyback loan for another 15% to avoid paying PMI insurance on the initial loan. The interest rate on the piggyback will be higher than on the primary mortgage. But it’s still tax-deductible and may cost less than you’d pay in mortgage insurance premiums.

This type of arrangement was fairly common before the 2008 crash but is used infrequently these days, and only for borrowers with good credit.

Is Private Mortgage Insurance worth it?

Some mortgage officers say you should avoid private mortgage insurance and do whatever possible to make a 20% down payment. That works if you can find a reasonable property where you can afford 20% down.

For many homeowners and homebuyers, it would take years to save up enough to put 20% down on any home, let alone a modest but decent one. Making a smaller down payment and paying for private mortgage insurance allows you to own a home and start building equity now, rather than paying that same amount of money on rent.

Waiting longer can also mean paying higher mortgage rates. By historical standards, mortgage rates have been unusually low since the 2008 crash. But there’s no guarantee how long they’ll stay there. If rates move up to more historical norms in the 6-10% range. You will end up paying a lot more than you would today, even with PMI added in.

Mortgage insurance can be a useful and cost-effective tool to help you realize your goal of owning a home without depleting your savings or taking a decade or more to save up a large down payment. Knowing how it works and the choices available can help you decide just how much of a down payment you actually need. It will help you narrow down your mortgage options as well.