Should PMI Keep You From Purchasing a Home?
What is PMI, and how do you calculate it? Private mortgage insurance can add to your monthly payments, but it shouldn’t prevent you from buying your first home.
January 7, 2022
Shopping for a home can be exciting and entirely overwhelming at the same time.
There are lots of hoops to jump through, fees to pay, and concepts to learn — particularly for first-time homebuyers.
“PMI” is a term that you’ve likely heard, and it’s the subject of much confusion for homebuyers.
But what is PMI — and what does it mean for you?
What is PMI?
PMI stands for “private mortgage insurance.” It’s a type of mortgage insurance you may need to pay if you take out a conventional loan to buy a house.
Although you pay for PMI each month, the insurance doesn’t protect you — it protects the lender who issued your mortgage.
If you default on the mortgage, PMI kicks in to cover a portion of the remaining balance of the loan.
What is PMI used for?
Private mortgage insurance is designed to reduce the financial risk to the lender (the bank that issues your mortgage).
Every time a lender issues a mortgage, they take on some level of risk. There is the chance that the borrower is unable to afford their payments at some point in the future.
PMI is designed to reduce this risk to a more manageable level.
Not only does this reduce risk on the lender’s side, it also makes lenders more willing to loan money to “riskier” clients. Specifically, it makes lenders more comfortable issuing mortgages to buyers with smaller down payments.
When is private mortgage insurance (PMI) required?
There are a couple of instances in which PMI is required:
For new mortgages: PMI is typically required when the down payment is less than 20%. For instance, if you plan to purchase a $400,000 home, you would need a down payment of at least $80,000 in order to avoid PMI. Any down payment smaller than this would likely require PMI.
For refinancing: PMI is typically required if you have less than 20% equity in the home (if your loan-to-value ratio, or LTV, is less than 80%). For instance, if you own a home that’s worth $300,000 at current market values, you would need to have a minimum of $60,000 equity in the home to avoid PMI on a refinance.
How to avoid PMI
There are a few main ways to avoid the cost of private mortgage insurance:
Make a down payment of 20% or more: Lenders only require PMI if you make a down payment less than 20% of the home value. If you can save up to get to this point, you can avoid PMI altogether.
Consider other types of loans: Some lenders may offer conventional loans that don’t include PMI, even if you have a low down payment. However, the interest rate will be higher. Likewise, FHA loans don’t require PMI, but they have their own type of mortgage insurance. These options could be cheaper or more expensive in the long run, compared to paying PMI — it all depends on your credit score, down payment amount, and other factors.
Continue paying off the loan: If you have an existing mortgage with PMI (or a refinanced loan), you can eventually cancel PMI once you reach 20% equity in the home (80% LTV ratio). Lenders will automatically cancel PMI once you reach a 78% LTV ratio, but you can request an early cancellation at 80%.
How much does PMI cost?
Nationwide, the typical PMI cost ranges from 0.19% to 1.86% of the mortgage amount, per year. This means that PMI on a $300,000 mortgage could cost as little as $570 per year, and as much as $5,580 per year.
In some cases, PMI rates may be even higher — it all depends on the borrower’s creditworthiness and the size of the loan, among other factors.
The majority of borrowers will receive PMI rates somewhere in the middle of this range. Freddie Mac estimates that most borrowers will pay between $30 and $70 per month for each $100,000 borrowed. Taking the same $300,000 mortgage example from above, that’s $90 to $210 per month, or $1,080 to $2,580 per year.
The percentage you pay depends on your credit score, the size of the down payment, and the size of the loan. PMI rates are lower for those with good credit scores and are generally higher for larger mortgages.
How to calculate PMI
To calculate your PMI payments, you’ll need to request your mortgage insurance rate percentage from the lender. This will likely be a percentage rate between 0.19% and 1.86%, as described above.
From there, you can use a PMI calculator to figure out your exact monthly costs. Alternatively, you can calculate PMI manually:
Find the property value (based on your offer amount, or recent appraisals).
Find the total loan amount by subtracting your down payment from the property value.
Calculate the LTV by dividing the loan amount by the property value, then multiplying by 100 to get the LTV percentage.
If the LTV is 80% or lower, you won’t pay PMI; if it’s higher than 80%, move on to step 5.
Take the total loan amount (from step 2) and multiply it by the PMI percentage from your lender. The result will be your annual cost for PMI.
Divide the annual PMI cost by 12 to find your estimated monthly PMI payments.
How long do you pay PMI?
You will pay PMI until you reach the point where it is no longer required by the lender. In many cases, this is when you have 20% equity in the home (meaning an LTV of 80% or better).
For instance, if you purchase a home with a 10% down payment, you will keep paying PMI until your equity in the home reaches 20%.
Should I pay off PMI early?
If you already have a mortgage with PMI, you may be wondering if it’s worthwhile to pay it off early.
There’s no way to directly pay off PMI early (although you may be able to prepay for it all upfront at the time of signing).
For existing mortgages, the question becomes whether it’s worthwhile to pay extra principal payments until you reach 20% equity, at which point PMI will no longer be necessary.
If you have the money to make additional payments, this isn’t a bad use of funds — although you may be better off investing that money.
When do you pay PMI?
Many borrowers will pay PMI monthly, and it’s typically added to the monthly mortgage payment.
You can also opt to pay PMI premiums upfront, at closing. This will add a substantial sum to closing costs, but will reduce your monthly mortgage payments going forward.
Wrapping up
Is PMI worth it? If paying PMI allows you to buy the home you want, then the extra expense is generally worthwhile.
After all, the alternative is waiting until you can afford a 20% down payment, which can take a substantial amount of time for some of us.
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