When you buy a home, there is a good chance that you aren’t entirely prepared for all the costs that come with a mortgage. Many homebuyers, when estimating what they are likely to pay when it comes to their housing costs, only think about the principal payment and the interest payment. A few homebuyers consider homeowners insurance and property taxes, but in many cases, homebuyers are surprised to discover how much closing costs and other costs add to the total mortgage amount and affect the monthly payment.
According to Trulia and Reader’s Digest, one of the top hidden costs to homebuyers is private mortgage insurance (PMI). You might be surprised at the added cost that comes from paying PMI, depending on your credit and the type of loan you get.
What is PMI?
Private mortgage insurance is basically protection for the lender. It’s designed to protect the lender in case you default on your loan. However, the lender doesn’t pay the premium for PMI; you do.
When you borrow to buy a home, it’s actually the lender’s money on the line. Chances are that you can’t afford to pay for a house with the capital that you have. That means that your lender is taking on most of the risk by providing the purchase funds. You are supposed to repay the lender (with interest), and if you don’t repay the loan, the lender has lost the money. The lender can repossess your home, but that comes with its own costs, which cut into profits.
One of the ways that lenders reduce the risk to the bottom line is by requiring a 20 percent down payment. In the years leading up to the financial crisis, according to data from the Urban Institute, homebuyers who offered 20 percent or more as a down payment were far less likely to default than those who offered lower down payments. While more recent data indicates that there isn’t as big a difference as in the past, the memory remains, and many lenders want to reduce the risk associated with lending to homebuyers that don’t make larger down payments.
PMI is a way to reduce that risk. If you don’t put 20 percent down on your home, your lender will probably require you to pay PMI premiums until the loan to value ratio on your home drops to the point at which you have 20 percent equity. If you default, the lender can recover some the money through the insurance payout.
How much does PMI cost?
According to Investopedia, PMI usually costs between 0.5 percent and 1.0 percent of the total loan amount on an annual basis. So, as you pay down your loan, your PMI premium should go down as well. However, you can see how it could be expensive. If you finance $180,000 to purchase a home, your PMI could be between $900 and $1,800 per year. That adds between $75 and $150 to your loan payment each month. That can make a difference — especially when you consider other costs that might be part of your monthly mortgage payment. You can see how costs keep adding up.
Your PMI cost is based on factors that can influence what you pay:
- Your credit: The lower your credit score, the higher your PMI premium, since credit rating can impact the risk that you will default. If you look like a higher default risk, you might be charged more for PMI.
- Loan purpose: What you plan to use your loan for matters. A refinance might have a different rate than a purchase. Additionally, purchasing a second home, or an investment property, might come with higher costs if you are perceived as a great default risk.
- Down payment size: Since your down payment reduces the amount you borrow, a bigger down payment means that your PMI premium is based on a smaller number. You pay less in PMI if you have a 10 percent down payment than if you have a 2 percent down payment.
Before you close on your loan, make sure that you understand the cost of PMI so that you can prepare for it in your monthly housing budget.
Getting rid of PMI
You don’t have to pay PMI premiums for the entire term of your loan. In fact, the government requires that lender to stop charging you PMI once you reach a certain amount of equity in your home.
The Homeowners Protection Act entitles you to request that the lender cancel your PMI when your principal balance falls below 80 percent of the original value of your home. So, if your home was worth $200,000 when you bought it, when your mortgage balance drops below $160,000, you can request to have your PMI canceled. If you don’t request the cancellation, your lender can continue to charge you premiums until the balance reaches 78 percent of the original value of the home. In the case of our example, the lender should automatically cancel at a balance of $140,400. You can see that paying attention makes sense, though, since you could save a couple thousand dollars by asking for cancellation rather than waiting for automatic termination.
If you want to get rid of PMI, here are the requirements you must meet, once your mortgage balance falls below 80 percent of the original home value:
- Be current on your payments
- Have a good payment history
- Make the request in writing
The lender does have some loopholes, though. The lender can request an appraisal to ensure that the home hasn’t fallen in value. If it has, you might not be able to cancel PMI. Additionally, a lender can also require you to certify that there aren’t other loans (such as a second mortgage) on your home.
Once you understand PMI, and how to save, you can plan how to pay as little as possible — and cancel it as soon as you can.
