Private mortgage insurance, or PMI, is often a substantial part of a homeowner's mortgage payment. Usually mortgage offerings don’t require any significant down payment on the home being purchased. When the down payment is less than 20%, lenders can charge mortgage insurance to help protect them in the case that the homeowner defaults on the loan.
What is PMI?
Mortgage insurance sounds like a benefit for a homeowner. Certainly, there are payment protection plans that allow for a homeowner's mortgage payments to continue during a time of illness or disability. However, private mortgage insurance is not a benefit for the homeowner. A PMI can be defined as a monthly premium paid to the mortgage originator due to the current lack of equity in the home. A PMI allows a homeowner to get a mortgage and make a down payment of less than 20%; the cost of a PMI ranges from 0.25% to 2% of your loan balance, and takes your down payment, credit score, and the duration of your loan.
LMI (lender’s mortgage insurance), is similar to PMI. It's also known as lender-paid PMI. Lender’s mortgage insurance is a form of PMI in which the lender “pays” for the private mortgage insurance. The lender doesn’t take on a monthly premium; instead, they receive a higher interest rate up front.
What Does Private Mortgage Insurance Insure?
When a homeowner defaults on a home, the lender typically takes possession of the property. In cases where the homeowner has paid a significant amount of the loan principal back to the lender, there is a lot of value in the home for the lender to utilize. For example, consider a home that is worth $150,000. If a borrower pays off $100,000 of the home before defaulting, the lender must only sell it for $50,000 to break even on the exchange. This is the reason why many bank sales of homes go for lower prices than comparable private sales.
However, if a homeowner still owes $145,000 on that home when they default, the bank must sell it at market price to break even. To mitigate the financial risk that the bank assumes when lending, they receive a monthly fee from the borrower. Typically, this fee is tacked on to mortgages where the loan to value ratio is 80% or greater.
Private Mortgage Insurance Tips For Borrowers
The good news is that there are ways to eliminate private mortgage insurance from monthly mortgage payments. If you are a veteran and qualify for a VA loan, PMI is not required. Lenders are required to inform borrowers when their loan to value ratio reaches 80%. At this time, borrowers should immediately contact their lender and request that private mortgage insurance be discontinued. Furthermore, lenders must discontinue the payments automatically when the loan to value ratio hits 78%.
Some mortgages can offer an equity loan that accounts for the lacking equity in the home. This will allow homeowners to avoid private mortgage insurance. However, the interest rates on these loans are often more costly than the mortgage insurance would have been. Also, some FHA loans and other types of mortgages can require private mortgage insurance payments for the life of the loan. Fortunately, both private mortgage insurance and interest are able to be deducted from income tax liability.