14: PMI Explained

by Local Title

Private Mortgage Insurance (PMI) is a type of insurance that protects lenders against the risk of borrowers defaulting on their mortgage payments. It is typically required when a borrower makes a down payment of less than 20% of the home’s purchase price. Understanding how PMI works, its costs, and its benefits can help borrowers make informed decisions when securing a mortgage.

What is PMI?

PMI is provided by private insurance companies and is designed to protect lenders in case a borrower defaults on their loan. Because a lower down payment represents a higher risk to the lender, PMI helps mitigate that risk by ensuring the lender is compensated if the borrower is unable to meet their mortgage obligations.

How PMI Works

When a borrower is required to carry PMI, they pay monthly premiums, which are added to their mortgage payment. The amount of the PMI premium depends on several factors, including the size of the down payment, the loan amount, the borrower’s credit score, and the loan-to-value ratio (LTV). Typically, PMI premiums range from 0.3% to 1.5% of the original loan amount per year.

For example, on a $200,000 mortgage with a PMI rate of 0.5%, the annual PMI cost would be $1,000, or approximately $83.33 per month. This additional cost can significantly impact the overall affordability of the mortgage.

Types of PMI

There are several ways PMI can be structured, and it’s essential to understand the differences:

Borrower-Paid PMI (BPMI)

Borrower-paid PMI is the most common type of PMI. The borrower pays the PMI premiums as part of their monthly mortgage payment. Once the borrower’s equity in the home reaches 20% of the original purchase price or appraised value, the PMI can usually be canceled upon request. Alternatively, the lender is required to automatically cancel BPMI when the borrower’s equity reaches 22%.

Lender-Paid PMI (LPMI)

In lender-paid PMI, the lender covers the cost of PMI and passes it on to the borrower in the form of a higher interest rate. While this option eliminates the separate PMI payment, it often results in higher overall costs over the life of the loan because of the increased interest rate.

Single-Premium PMI

Single-premium PMI involves paying the entire PMI cost upfront as a one-time payment at closing. This can either be paid by the borrower or financed into the loan amount. This option avoids monthly PMI payments but requires a larger amount of cash upfront or increases the loan balance.

Split-Premium PMI

Split-premium PMI combines aspects of both borrower-paid and single-premium PMI. The borrower pays a portion of the PMI cost upfront at closing and the remainder through monthly payments. This reduces the monthly PMI cost compared to BPMI and requires a smaller upfront payment compared to single-premium PMI.

Benefits of PMI

While PMI increases the cost of a mortgage, it offers several benefits:

Easier Homeownership

PMI enables borrowers who cannot afford a 20% down payment to purchase a home. This makes homeownership accessible to a broader range of individuals, especially first-time buyers.

Faster Entry into the Market

By allowing for a smaller down payment, PMI helps borrowers enter the housing market sooner. This can be advantageous in appreciating markets where home prices are rising.

Costs of PMI

The primary disadvantage of PMI is the additional cost it adds to the borrower’s monthly mortgage payment. This increases the overall expense of homeownership and can impact the borrower’s budget.

Canceling PMI

One of the key aspects of PMI is that it can be canceled once certain conditions are met. For borrower-paid PMI, homeowners can request cancellation when they reach 20% equity in their home. Lenders are required to automatically cancel BPMI when the borrower’s equity reaches 22%. For single-premium or lender-paid PMI, cancellation policies vary and may require refinancing to eliminate the PMI cost.

Understanding PMI, its types, and its implications can help borrowers make informed decisions about their mortgages. While PMI adds to the cost of a mortgage, it also opens the door to homeownership for those who might not otherwise be able to afford it.