Traditionally, people buying a home can expect to pay around 20% of the total price as a down payment. In a modern housing market, where many homes sell for around $200,000 to $500,000, homebuyers will need to save between $40,000 and $100,000 before they begin to look for a house or for a home loan lender. However, a down payment of this size can require a lifetime of savings, making it out of reach for many potential buyers. As a consequence, people who could easily afford a mortgage but lack the cash to make the expected down payment can feel trapped in the renter’s market.
Fortunately, there are ways to qualify for a home loan that don’t require such a substantial down payment. Acquiring private mortgage insurance is one of those ways. What is mortgage insurance? How does it help you get a home loan? When is it required? Read on to learn more about private mortgage insurance and how it can help make owning a home a reality.
Private mortgage insurance, or PMI, is a way to protect the lender should the buyer, at some point, default on their home loan. The lower the buyer’s down payment is, the larger the risk for the lender. Mortgage insurance mitigates that risk by guaranteeing a portion of the principal to the lender in the event that the buyer can no longer make their payments.
For example, if a buyer defaults on their mortgage after paying only 25% of a home’s $200,000 price, the lender would stand to lose about $150,000. However, if the buyer had been paying mortgage insurance, the PMI would reimburse 25% of the lender’s loss—around $37,500. It would also cover 25% of the delinquent interest they had accrued and 25% of the lender’s foreclosure costs. This is all to say that, although the homeowner pays for the PMI, the insurance protects the lender, not the buyer. That said, it still benefits the buyer by reducing the overall amount of risk, persuading the lender to work with folks who may need a helping hand when purchasing a home.
The cost of the insurance is added to the buyer’s monthly loan payments and referred to as a “premium.” With certain exceptions for government-backed loans, any lender will require private mortgage insurance if the buyer is making a down payment that is less than 20% of the house’s cost. The cost of the mortgage insurance is borne by the buyer and will vary depending on the buyer’s credit score and the overall cost of the home. Mortgage insurance, however, can allow someone to buy a home with a low or even no down payment.
The average cost of PMI is between 0.55% and 2.25% of your total home loan. If your home costs $300,000 and you’ve made a 3% down payment of $9,000—your PMI could add between $150 and $545 to your early monthly payments.
You can influence the cost of your mortgage insurance by increasing your credit score, saving for a larger down payment and working with a lender you trust, one that will attempt to get you the best possible rate. While all lenders (banks, mortgage brokers and credit unions) require PMI for below-20% down payments, certain lenders, like Solarity Credit Union, have negotiated lower-cost PMI rates for their members. If you choose to use PMI to purchase a home, you should ask whether the lender has negotiated any reduced rates.
There are upsides and downsides to purchasing mortgage insurance. The most obvious advantage is that it can help first-time homeowners tremendously. Saving enough to purchase a home without PMI can seem like an impossible task. However, financial counseling and a sound financial strategy may make saving for a down payment easier than you think. It’s important to consider the right strategy for you because mortgage insurance will increase your monthly payments, at least initially.
A little pencil-and-paper planning can go a long way toward helping you decide if PMI is right for you. If you are currently renting, it could take five years or more to amass a 20% down payment. Though you’d likely spend the first five years of your home loan paying off your mortgage insurance, the home you’ve purchased will also have been appreciating in value over that same period, likely around 2% to 3% per year. Depending on your financial stability, your expected earnings and how much you pay in rent annually—you may find that you’re ahead after five years.
Some buyers make a trade-off between paying PMI and using what would otherwise be a large down payment to renovate or furnish their new home. You may also decide that the increased payments are not worth the risk. Everyone’s situation is unique, and buying a home is a big decision. The most important part is that you investigate all of your options and arm yourself with the most accurate information you can find.
Mortgage insurance is regulated by the Federal Homeowners Protection Act, or HPA. This law states that lenders must automatically remove the PMI once the buyer has repaid 78% of the home’s original value. Some lenders will remove PMI earlier, and this is another useful thing to ask about when choosing the lender that you want to work with. It’s also true that loan investors, such as Fannie Mae, sometimes have their own PMI cancellation guidelines—but those can’t supersede HPA regulations. In general, your PMI is removed when you’ve proven to your lender that you’re no longer a high risk.
Of course, there are caveats. In order to have your PMI removed, you must have a generally positive payment history. Your home has to have maintained its value, and you cannot have secondary liens against the property, such as a second mortgage. If you are making your payments on time, you can expect to make your PMI payments for about five years.
Special circumstances may apply for certain mortgages. For instance, if your mortgage has an interest-only period, principal forbearance or balloon payment (all designed to keep initial monthly payments artificially low or to pause payments in the event of a serious financial loss), your PMI will be canceled once you reach the midpoint of your loan’s amortization schedule. For example, if you have a 30-year mortgage with a balloon payment, your PMI payments will cease after 15 years.
The bottom line is that there are options if you’re looking to purchase a home. Speaking to a trusted lender or financial advisor, such as a Home Loan Guide at Solarity Credit Union, can help you decide what’s best for you.