What is private mortgage insurance and why does it matter?

What is private mortgage insurance and why does it matter?

PMI comes with pluses and negatives. Should you put less than 20% down on a home and pay a PMI premium each month?

Commonly referred to as PMI, private mortgage insurance is a type of insurance that insures your lender against loss from default if you are putting less than 20% down with a conventional home loan.

PMI is provided to you by a private mortgage insurance company, and is arranged by your lender when putting together a loan. Unless you are taking advantage of a special low-down-payment loan product such as a doctor loan, it is likely that your lender will require you to buy PMI if you’re putting less than 20% down with a conventional loan.

If you end up defaulting on your mortgage, the PMI helps the lender recoup the cost differential between the amount of money you put down and whatever amount of money a 20% down payment would have been.

How much is PMI?

According to Freddie Mac, you should expect a monthly PMI payment of between $30 and $70 for every $100,000 borrowed. According to Zillow, the median home price of currently-listed homes in the United States is $282,000. With this in mind, if you’re putting 10% down on the median home in the US, you’ll be borrowing $253,800.

For that loan, you’ll be paying a PMI premium of between $76 and $178 per month, depending on a number of factors such as your creditworthiness and debt-to-income ratio.

If a lender is requiring PMI because you’re using a conforming loan and putting down less than 20%, you’re going to be required to continue paying the PMI premium up until you have paid down your mortgage to an 80% loan-to-value ratio. If you’re current on your mortgage payments, the PMI premium will automatically drop off when your principal balance is set to be 78% of the initial value of your home.

Sometimes, lenders do offer conforming loans that do not require PMI, however know that you will have to pay a higher interest rate for the life of the loan in order to access these products.

Why bother with PMI?

Why would you want to sign up for an extra monthly payment!? Before casting PMI aside out-of-hand, there are a couple important things to consider as you determine the amount of cash you want to put down for your new home.

While the PMI premium is a pesky additional cost that you will have to bear each month, it does save you a big chunk of change on the down payment. To use the above example of a $282,000 home purchase putting 10% down, if you had a 3.8% interest rate your monthly payment with PMI of 0.5% of loan amount would be $1,288.35 (note that we are ignoring home insurance and property tax costs).

All told, you would need to make 79 payments of $105.75 in PMI to get to a loan balance of $219,850.75. Why is this a magic number?

In the 79th month after buying your home you would officially be below 78% loan-to-value ratio of the original purchase price of $282,000 and your PMI payment would automatically terminate. In total, you would have paid $8,354.25 in PMI over a period of over 6.5 years.

In return for that payment, however, you saved an additional down payment of $28,200 when you initially bought the home.

Everyone’s financial situation is different, but PMI is not always a bad thing. In this example, you saved over $20,000 in cash that would have gotten you to a 20% down payment, and the PMI provider insured your lender against the slightly-higher risk involved in a lower down payment.

PMI is a helpful tool to conserve your cash and use it for other things like saving for retirement. It is particularly useful when mortgage interest rates are low because you can leverage the bank’s cash and keep yours for a higher return elsewhere.

Why does PMI matter?

PMI is a bit of grease in the massive U.S. mortgage market. The insurance product protects lenders from a higher risk of default and opens up home ownership to a wider swath of potential buyers who otherwise wouldn’t be able to afford a home. It comes with both positives and negatives, as do most financial products.

Keep in mind that PMI is an insurance product that is somewhat unusual in the pantheon of insurance products. Instead of protecting you against personal loss, as in the case with home, auto, or travel insurance, PMI protects your lender against loss. If you stop paying and go into default, you can still lose your home via the foreclosure process. The PMI won’t help you, however it will help your lender recoup lost money.

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