First-time homebuyers may not realize that taking out a mortgage has a few financial requirements. Mortgage lenders will require you to buy homeowners insurance and you may also need to get private mortgage insurance, or PMI.
Private mortgage insurance is generally required by mortgage companies if you take out a conventional loan and your down payment is less than 20% of the home purchase price. PMI payments, called premiums, protect the mortgage lender in case you stop paying back your loan.
PMI payments are calculated as a small percentage of the original mortgage loan amount. The average PMI rates for fixed-rate mortgages run anywhere from 0.2% to 2%. You can make PMI payments in a few different ways, depending on the mortgage servicer. Most commonly premiums are tacked on to your monthly mortgage payment, but borrowers can also choose to make some or all PMI payments up front. (There are however some downsides to this, which we’ll discuss.) Borrowers can cancel PMI once their home equity exceeds 20% or avoid it altogether by getting a higher interest rate on their mortgage — though this may not make financial sense in the long run.
Mortgage insurance is also required if you take out an FHA mortgage with the Federal Housing Administration. Mortgage insurance for FHA loans is called MIP, which is the same in concept, but has a few significant differences.
How does PMI work?
Private mortgage insurance is an insurance policy that most lenders require you to buy when your down payment is less than 20%. The down payment is a dollar amount that you pay at closing when you buy a house. For example, if you make a down payment of $30,000, or 10%, on a $300,000 house, then the mortgage lender will require you to get PMI.
The down payment plays directly into the loan-to-value ratio, or LTV, which is important to understanding how PMI works. The loan-to-value ratio is a way of indicating how much equity you have in your home, which is another way of saying how much of your house you own — how much of the mortgage you’d paid off — up to that point. If your home equity is 20%, then your loan-to-value ratio is 80%.
Private mortgage insurance is insurance for the lender; it protects them in case the borrower stops making mortgage payments. Even if the borrower faces foreclosure, they must keep paying PMI.
People can’t shop around for private mortgage insurance like they would with other types of insurance. Rather, PMI is determined by your mortgage lender, who contracts with a PMI company that provides the PMI coverage.
You can pay for private mortgage insurance in a few different ways, depending on your lender:
Borrower-paid mortgage insurance (BPMI)
Borrower-paid mortgage insurance is the most common PMI payment plan. The mortgage insurance premiums are simply added to your monthly mortgage payment. Your PMI payments, along with your property taxes and homeowners insurance, are typically paid through an escrow fund set up by your bank.
These PMI payments are usually fixed throughout the duration of your mortgage, so if you notice that your total monthly mortgage payment has increased, it’s probably because your property taxes or homeowners insurance premiums went up — not your mortgage insurance.
(If your home insurance rates have increased, you should shop around for lower rates. You can speak with a licensed representative at Policygenius to find a policy that works for your needs.)
Single-payment mortgage insurance
Single-payment mortgage insurance or single-premium mortgage insurance lets you pay all of your mortgage insurance at closing in one lump sum instead of monthly payments.
It might seem nice in theory to pay PMI at once and not have to worry about it again. However, you could be losing money in the long term with this type of mortgage insurance if you decide to sell the house or refinance your mortgage loan in a few years before your loan term has ended, since you can’t ask for any of those PMI payments back.
Paying PMI upfront might also not be financially practical, since borrowers could use that money toward the down payment instead. Making a larger down payment means you’d have a lower principal loan balance (and less total interest overall), which could save you thousands of dollars over the lifetime of the loan.
Split-premium mortgage insurance
With split premiums, you make some PMI payments up front, and the rest as part of your monthly mortgage payments. Split premiums pay can be a helpful option if you don’t have enough cash to make a single payment up front for PMI in its entirety, but still want to have more disposable income.
How much is PMI?
The PMI premium rate is usually anywhere from 0.2% to 2%, or even up as high as 5%, if you pay it all at once.
PMI is calculated based on a number of factors, including:
Mortgage loan amount
Down payment or loan-to-value ratio
Payment terms, like loan term and whether it you have a fixed-rate or adjustable-rate mortgage.
Calculating your PMI payment is straightforward. Let’s say your mortgage loan amount is $350,000 and PMI rate is 0.7%. Calculate 0.7% of $350,000 (0.007 x $350,000), which is $2,450 in annual payments. Now divide that by 12 for the monthly mortgage insurance premium, which turns out to be $204.
Can you avoid paying PMI?
The best way to avoid PMI is to make a down payment of 20% or more. However, this isn’t achievable for most people and others might prefer to have that money at their disposal to use for other things. Only you can decide if 20% is worth it.
But if you’re still set on avoiding PMI, you do have an option.
How to avoid PMI without 20% down
Borrowers can opt to get a higher interest rate on their mortgage, in exchange for having their mortgage lender pay the PMI on their behalf. This type of PMI is called lender-paid private mortgage insurance or (LPMI). Whether or not avoiding PMI is financially beneficial for you depends on the rates you get, so it’s important to get quotes from your loan servicer and compare since even a fraction of a percentage point can make a difference.
Let’s look at this example of borrower-paid versus lender-paid mortgage insurance for a 30-year fixed-rate mortgage. We got the numbers using our mortgage calculator, which shows you an amortization schedule with of all your projected monthly payments.
Mortgage insurance type | BPMI | LPMI |
|---|---|---|
Loan amount | $350,000 | $350,000 |
Mortgage interest rate | 3.75% | 5% |
Mortgage payment (monthly) | $1,621 | $1,879 |
PMI rate | 0.70% | None |
PMI payment (monthly) | $204 | $0 |
Total | $1,825 | $1,879 |
In this example, having the lender pay PMI will actually require you to make higher monthly payments — $54 more. Also keep in mind that if you choose BPMI, you will eventually get to stop paying PMI once you reach enough equity, so your payments would no longer include the $204.
Unlike borrower-paid PMI, you’ll need to pay this extra cost for the whole duration of the loan. However, you may be able to claim a greater mortgage interest deduction. Talk with a tax advisor to see if the savings would be worth it.
How to get rid of PMI
You can stop paying PMI once you’ve reached 20% to 22% equity in your home, depending on the lender’s terms. You can find those terms, as well as the day you’re supposed to hit 80% LTV (according to an amortization schedule), on the closing disclosure form you received when you took out the mortgage.
The fastest way to reach 20% equity is by prepaying or making an extra mortgage payment or even recasting your mortgage to pay down more of the principal.
Your lender may automatically cancel PMI
On the day that you’ve reached 22% equity in your home — meaning the principal balance of your mortgage is 78% of the original value of the home, your bank is required by law to cancel PMI. This is strictly based on how much of the mortgage the borrower has paid.
You can request that your lender cancel PMI
If you can’t wait until you have 22% equity in the home, you can actually ask your mortgage lender to cancel your home once you’ve reached 20% equity (the principal balance of your mortgage is now 80% of the value of your home).
The lender might oblige if you meet certain criteria, like having a good payment history and not having any liens on the house. They might also require you to get an appraisal to make sure the home hasn’t depreciated. Borrowers typically pay for the appraisal (a few hundred dollars or more), so if you go this route, you should be confident that your home hasn’t depreciated.
You can have your house reappraised
If the local real estate market is booming or you’ve made some home renovations that have caused your house to appreciate in value, then you can choose to get an appraisal on your own. If you’re successful, the house will be appraised at a higher value and you may end up with a lot more equity in the home — maybe even enough to cancel PMI.
You can cancel PMI by refinancing
If your credit score increased or your debt-to-income ratio is more favorable than it was when you first took out the mortgage, you might consider refinancing your mortgage. A mortgage refinance is essentially taking out a new mortgage to pay for your old one, so you can get lower mortgage rates or change other features of your mortgage. If you opt for a cash-out refinance, you use the cash the pay down enough of the principal to reach an 80% LTV ratio and avoid PMI.
When mortgage rates are low, refinancing can be a good idea, keep in mind that you’ll have to pay closing costs again, so make sure that the long-term savings are worth the upfront costs. Also, keep in mind that the opposite scenario can also be true when refinancing: you may end up with a loan-to-value ratio greater than 80%, in which case PMI payments would be required.
PMI for government loans
As mentioned earlier, you also pay mortgage insurance when you take out a government-insured loan from the Federal Housing Administration (FHA). PMI for FHA loans is called MIP, or mortgage insurance premiums, and must be paid as part of your monthly mortgage payment. The insurance premium rates for FHA loans also don’t rely on the borrower’s credit score, unlike conventional loans.
MIP and PMI are similar, as they are types of insurance that are meant to protect the lender, but the cancellation terms are very different.
Furthermore, cancellation terms for FHA loans vary based on when the mortgage was taken out. For FHA loans taken out after 2013: borrowers pay mortgage insurance premiums throughout the life of the loan if their LTV ratio is greater than 90%. If a borrower’s LTV is under 90%, they will only pay mortgage insurance premiums for 11 years.
Prior to 2013, MIP cancellation depended on more factors, like the loan term. You can see the chart below:
TERM | LTV (%) | BEFORE 2013 | AFTER 2013 |
|---|---|---|---|
≤ 15 years | ≤ 78 | No annual MIP | 11 years |
≤ 15 years | > 78 - 90 | Cancelled at 78% LTV | 11 years |
≤ 15 years | > 90 | Cancelled at 78% LTV | Loan term |
> 15 years | ≤ 78 | 5 years | 11 years |
> 15 years | > 78 - 90 | Cancelled at 78% LTV & 5 years | 11 years |
> 15 years | > 90 | Cancelled at 78% LTV & 5 years | Loan term |
Mortgage insurance for VA loans
VA loans — the no-down-payment loans offered for servicemembers and veterans — don’t have mortgage insurance premiums, but they do include a “funding fee,” which offsets loans that go into default. You typically have the option of paying the entire fee up front with the closing costs or including it in your monthly mortgage payment.
Mortgage insurance for USDA mortgages
USDA loans — mortgages for rural home buyers with low income for their area — offer split-premium mortgage insurance at low rates. For USDA loans, you pay a $1.00% up-front fee based on the size of the loan, followed by a 0.35% annual fee that’s paid on the remaining principal balance for the life of the loan.
Mortgage protection insurance
Mortgage protection insurance is a form of life insurance that keeps making your mortgage payments if the primary earner dies. Otherwise, if you died and your family wasn’t able to make the payments, they would lose the home.
Whereas PMI protects the lender, mortgage protection insurance protects the borrower. Mortgage protection insurance terms are typically the same length as your mortgage terms, so 15, 20, or 30 years.
