What is private mortgage insurance (PMI)?
Most home buyers will generally borrow more than 80% of a home’s purchase price to finance the purchase. To protect the lender, the home buyer will be required to pay for an insurance policy for the lender that reduces the risk of a potential loss in the case of foreclosure. This insurance is known as private mortgage insurance (PMI).
Though a home buyer may scoff at the idea of paying insurance for the lender that has no direct benefit for him/her, the reality is that mortgage insurance allows a home buyer to:
1) Become a home owner sooner. To buy a home without mortgage insurance, the home buyer will generally need to make a 20% or greater down payment on the home. If the sales price is $100,000, for example, the home buyer will need $20,000 to purchase the home. Mortgage insurance, on the other hand, allows the same home owner to purchase that home with as little as 3% or $3,000 in this example.
2) Increase the home buyer’s purchasing power. Mortgage insurance allows a home buyer to purchase more home. Assume a young couple has saved $10,000 for the purchase of a home. Without mortgage insurance, their $10,000 down payment would only allow them to purchase a $50,000 property ($50,000 x 20% = $10,000). On the other hand, mortgage insurance gives the young couple more options. They could make a 10% down payment on a $100,000 home ($100,000 x 10% = $10,000) or even make a 5% down payment and use the remaining 5% for decorating, investing, or take a vacation.
3) Gain tax advantages. By making smaller down payments, a borrower may gain tax advantages because he/she will have more deductible interest to claim.
This should not be confused with other forms of insurance. Hazard insurance is designed to protect the home owner from any loss due to specified hazards such as a fire. Home owner’s insurance protects a the owner if the house and/or its contents suffer from unforeseen occurrences such as weather damage or theft. Mortgage life insurance is an insurance policy that provides financial protection for the home owner and/or his/her family in the case of the home owner’s death.
The cost of private mortgage insurance will depend upon the percentage of down payment and the type of loan. Most home buyers will pay approximately 7/10th of 1% of the loan amount for mortgage insurance (on a $100,000 loan, that equates to approximately $65.00 per month for mortgage insurance).
Do you need private mortgage insurance (PMI)?
From a lender’s standpoint, most loans with less than a 20% down payment needs mortgage insurance, even if the borrower has excellent credit. This is due to the fact that lenders can lose a great deal of money on an unpaid mortgage.
As mentioned in other sections, there are two factors that will determine if a home buyer needs mortgage insurance: 1) the amount of the down payment and 2) the type of loan.
As stated before, home buyers who make less than a 20% down payment on a home will generally need mortgage insurance. However, it is important to note that the larger the down payment, the less a buyer will pay in mortgage insurance. The following table illustrates this point:
| % down | 30 year fixed | 15 year fixed | 1 year ARM |
|---|---|---|---|
| 5% | 0.78% | 0.72% | 0.92% |
| 10% | 0.52% | 0.46% | 0.65% |
| 15% | 0.32% | 0.26% | 0.37% |
As you can see, a $100,000 mortgage with 5% down will have a monthly mortgage insurance payment of $65.00 ($100,000 x 0.0078 / 12) while a $100,000 mortgage with 15% down on the home will have a mortgage insurance payment of $26.67 per month ($100,000 x 0.0032 / 12).
The type of loan a borrower chooses will have an impact on the amount of mortgage insurance, if any, that is paid to the lender. Most conventional loans with less than a 20% down payment will require mortgage insurance. This includes 30 year or 15 year fixed rate loans, adjustable rate loans, intermediate arms, and balloon mortgages for a primary residence, second home, or investment property. FHA loans have mortgage insurance while VA home loans do not require monthly mortgage insurance.
How to avoid private mortgage insurance (PMI)
As most home buyers may have already figured out for themselves, the easiest way to avoid mortgage insurance is to make a down payment of 20% or more on a home.
However many potential home buyers often overlook other potential sources of additional cash than a checking or savings account. These sources include:
* Borrowing against a 401K retirement plan
* Taking a margin loan against stock
* Asking a relative for a gift
* Refinancing a car or other asset to pull cash out
* Selling a car, jewelry, or other asset
If a home buyer is unable to make a 20% down payment, there are other options to consider. They include:
Lender Paid PMI: Lender paid PMI is a program where the lender pays the mortgage insurance premium. The catch is that the interest rate is higher than normal (ranging from 0.75% to 1.5% higher) thus translating into a higher mortgage payment. However, the overall net effect is minimal when the buyer compares the higher payment to a lower payment with mortgage insurance. The main advantage is that there is a larger tax deduction for the home owner because the mortgage insurance is wrapped into a higher interest rate and thus more interest is paid on the loan. The disadvantage is that the home buyer has a higher interest rate. Had he/she opted to pay the mortgage insurance separately, he/she could cancel it when there is a 20% to 25% equity margin in the property.
Second Mortgages: In some cases, the home buyer may compensate 10% to 15% of the down payment for a second loan which allows the home buyer to avoid mortgage insurance. Second mortgages may come from the lender, the seller, or even a relative or family member. The most common scenarios are as follows:
* 80/10/10: The borrower applies for a first mortgage for 80% of the purchase price, a second mortgage for 10% of the purchase price and makes a 10% down payment
* 80/15/5: 80% first mortgage, 15% second mortgage and a 5% down payment
* 80/20/0: 80% first mortgage, 20% second mortgage and no down payment
It is important to mention that the second loan will result in a higher interest rate and the overall payment may be marginally less than a loan with mortgage insurance. However, the interest on the second mortgage is usually tax deductible for the home owner.
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(To be continued)
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