If you're a first-time homebuyer, you're probably going to run into 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 of less than 20 percent of the 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 significant effect on what you pay for pmi insurance, so it's important to know what those options are and to have a basic understanding of mortgage insurance overall.
How does PMI work?
PMI stands for private mortgage insurance. It helps ensure that your lender will be able to recover its money in the event you default on the loan and it goes into foreclosure. It's often charged on conventional loans, which is the term used for mortgages backed by Fannie Mae or Freddie Mac.
Mortgage lenders like to have a 20 percent down payment to provide themselves with a financial cushion against default – that's money in hand that can cover the cost of foreclosure and guard against the possibility the home may decline in value.
They're usually willing to accept a lower down payment, but that represents a greater risk to them. So they require PMI /mortgage insurance to cover the difference between your down payment and 20 percent. So if you put 5 percent down, your PMI insurance will pay the lender 15 percent of the home's sale price in the event you default on the mortgage.
So you pay the mortgage insurance premiums, but it's the lender who's being insured. That might not seem fair, but the PMI cost represents the added risk the lender is taking on with a smaller down payment – so you pay for it.
How much is PMI?
Mortgage insurance rates for PMI vary according to a number of factors, primarily your credit score and the amount of your down payment. For most borrowers, mortgage insurance premiums will be an annual fee 0.35-0.9 percent of your loan amount, billed as part of your mortgage payments in equally 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 percent and borrowers with poor credit.
FHA mortgage insurance is structured somewhat differently. With an FHA home loan, you pay an initial mortgage insurance premium of 1.75 percent of the loan amount at the time of the loan, and then an annual fee that for most borrowers is 0.85 percent of the loan amount, billed as a monthly charge on the mortgage statement. That figure can be as high as 1.05 percent on jumbo loans and as low as 0.45 on 15-year mortgages.
PMI vs. FHA mortgage insurance
Aside from the different fee structures, there are some significant difference between PMI and FHA mortgage insurance. For one, FHA mortgage insurance premiums are not tied to your credit score, unlike PMI mortgage insurance rates.
The big difference though, is that it's easier to cancel PMI once you acquire sufficient home equity. You can have PMI canceled once you reach 20 percent home equity, either by paying down your loan or through an increase in property value (an appraisal may be required). Your lender also must cancel PMI automatically when your loan balance falls to 78 percent 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 percent 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 percent equity, but that's considerably more costly than simply being able to cancel it as you can with PMI.
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 PMI tax-deductible?
Historically, PMI and FHA mortgage insurance have not been tax-deductible but Congress passed legislation in 2007 making both deductable 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 PMI is lender-paid mortgage insurance, or LMPI. In this case, the lender self-insures the loan by charging you a somewhat higher mortgage rate, usually a quarter to half a percentage, rather than having you pay mortgage insurance premiums.
The big advantage of LPMI is that it's tax deductible, since the cost is part of your mortgage rate – and you don't have to worry about Congress extending it. The downside is that you can't cancel it once you reach 20 percent equity – it's a permanent feature 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 LPMI as a single fee at closing. In that case, you don't get the tax deduction because it isn't part of your mortgage rate.
Using a piggyback loan to avoid PMI
You can sometimes avoid paying for PMI or FHA mortgage insurance by using a piggyback loan. This is a type of second mortgage used to cover the difference between your down payment and 20 percent, so you don't have to pay mortgage insurance premiums on the primary loan.
So if you put 5 percent down, you might take out a piggyback loan for another 15 percent to avoid paying PMI insurance on the primary 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 prior to the 2008 crash, but is used infrequently these days, and only for borrowers with good credit.
Is PMI worth it?
Some financial writers say you should avoid PMI/mortgage insurance and instead strive to make a 20 percent down payment. That works if you can find a more modest property where you can afford 20 percent down.
For many aspiring homeowners though, it would take years to save up enough to put 20 percent down on any type of home, let alone a modest but decent one. Making a smaller down payment and paying for PMI/mortgage insurance allows you to own a home and start building equity now, rather than paying that same money on rent.
Waiting longer can also mean paying higher mortgage rates. By historic 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 historic norms in the 6-10 percent range, you'd 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, and will help you narrow down your mortgage options as well.