What Is Private Mortgage Insurance (PMI), And How Do I Avoid It?
*As of July 6, 2020, Rocket Mortgage® is no longer accepting USDA loan applications.
Mortgage insurance provides a lot of flexibility when purchasing a home. If you’re among the many homeowners who can’t quite afford a 20% down payment, mortgage insurance gives you the option to put less money down. In exchange, an extra fee is added to your monthly mortgage payment.
You may be able to avoid paying mortgage insurance. If you do have to pay mortgage insurance on a conventional loan, you can eventually remove it. Either way, understanding how mortgage insurance works and how it applies to you as a home buyer will help save you money in the long run.
What Is PMI?
Conventional mortgages, which are backed by either Fannie Mae or Freddie Mac, often require private mortgage insurance (PMI) when less than 20% of a home’s purchase price is provided as a down payment. Usually, borrowers pay a monthly premium to a private insurer to cover PMI, although there are a couple of other ways to pay the premium. In the event that a home buyer defaults on their loan, the insurance company covers a portion of the lender’s loss.
It's important to note that if you fall behind on your payments, you still run the risk of losing your home through foreclosure. The insurance policy is strictly for the benefit of the lender in case this happens. From the point of view of the person getting the mortgage loan, the good thing about mortgage insurance is that it enables them to get a loan without needing to liquidate their savings to afford a down payment of 20% or more.
Do All Lenders Require Private Mortgage Insurance?
It would be safe to say that most lenders require private mortgage insurance for most of their loans which have a down payment of under 20%. Much of the time, the rules are set by conventional mortgage investors Fannie Mae or Freddie Mac. However, conventional loans aren’t the only loans you can buy PMI for and not every lender requires it in every scenario.
As an example, the Jumbo Smart loan from Rocket Mortgage® is for clients looking to borrow an amount higher the local conforming loan limits for real estate. These loans require a minimum of a 10.01% down payment depending on the loan amount, but they don’t have any PMI requirements. When shopping around, it doesn’t hurt to ask wonders whether PMI will be necessary.
How Much Is PMI?
Although it can vary, a good general guideline is that PMI costs 0.5% – 1% of the loan amount annually.
There are several ways to pay PMI. The options available to you depend on your lender. Most commonly, PMI is paid as a monthly premium that’s added to your mortgage payment to go along with property taxes, homeowners insurance and homeowners association dues. Other options include an upfront premium paid at closing and a combination of upfront and monthly premiums. When you receive a Loan Estimate from your lender, your PMI information will be included.
The PMI rate is based on several factors. Here are a few of the most important:
- Loan amount
- Down payment or equity amount
- Property type
- Debt-to-income ratio (DTI)
- Median FICO® Score
- Term of the loan
Also considered are whether you're taking cash out and the type of your loan. Adjustable-rate mortgages (ARMs) are considered a bigger risk than fixed-rate mortgages so the PMI will be slightly higher with those.
Types Of PMI
The cost of PMI is also determined by the specific type of PMI you take out. There are two types of PMI:
- Borrower-paid (BPMI)
- Lender-paid (LPMI)
BPMI is the most straightforward. It’s a monthly fee added on to your mortgage insurance that can be removed once you reach 20% home equity.
LPMI programs like PMI Advantage allow you to avoid a monthly mortgage insurance payment in exchange for paying a slightly higher interest rate than you would on a loan without LPMI. It’s important to note that this higher interest rate sticks around for the life of the loan. Depending on market conditions at the time, you may be able to save money in a couple years by refinancing at a lower rate without mortgage insurance once you reach at least 20% equity in your home.
A variation of LPMI lets you pay for part or all of the PMI policy in a lump sum at closing. If you make a partial payment, you’ll get a lower interest rate with LPMI. If you pay for the whole policy, you’d get a rate identical to the one you’d receive if you weren’t paying LPMI, but it would be without the extra monthly payment associated with BPMI, regardless of the size of your down payment.
Example Premium Cost
To give you an idea of how much you can expect to pay for mortgage insurance, let’s take an example from major mortgage insurance provider MGIC. When you read this chart, you’re going to see something called LTV, a comparison of your outstanding loan balance to your home value. This stands for loan-to-value ratio and you can think of it as the inverse of your down payment or equity amount. For example, your LTV would be 97% if you had a down payment of 3%.
For this scenario, let’s assume your mortgage lender has determined you need the maximum coverage amount of 35% based on having a 3% down payment. Further, let’s also assume you have a credit score of 750. This is a $300,000 30-year fixed-rate loan with BPMI.
By looking at the first table on the sheet, we see that the BPMI price for our scenario is 0.7%. This means that your annual mortgage insurance cost is 0.7% of your overall loan amount. This is divided into monthly PMI payments so that your monthly cost is actually $175 ($300,000 × 0.007 equals $2,100/12 = $175).
It’s worth noting that, although we based this example on public rate sheets, lenders negotiate their own rates with mortgage insurers. Therefore, the mortgage insurance cost is certainly something to consider when comparing lenders. Rocket Mortgage® is able to get some of the lowest rates available in the industry for our clients for both BPMI and LPMI.1 When shopping, PMI premiums can be another point comparison.
PMI Vs. MIP
So far we’ve talked about private mortgage insurance when it comes to conventional loans. However, PMI is not the only type of mortgage insurance. Let’s start by talking about mortgage insurance associated with FHA loans.
While PMI is provided by private insurance companies, the Federal Housing Administration handles the mortgage insurance premiums (MIP) that FHA borrowers pay. MIP is required on all FHA loans for which an application was completed after June 3, 2013.
An FHA loan is a great option for first-time home buyers because it has lower down payment and credit score requirements (3.5% and 580 median FICO®, respectively).
How Does MIP Work?
If you have an FHA loan, you pay a portion of the premium up front at the close of the loan and then continue to pay mortgage insurance premiums on a monthly basis. The upfront premium is always 1.75% of the loan amount. If you can’t afford to pay this at closing, it can be financed into your loan amount.
In addition to the upfront premium, there’s an annual premium that’s based on your loan type as well as your down payment or equity amount. If you have a standard FHA loan with a 3.5% down payment on a loan of no more than $625,500, the annual MIP is 0.85% broken into monthly payments.
If you have an FHA Streamline where you go from one FHA loan to another for the purpose of lowering your rate and/or changing your term, the MIP rates are a little better. In this case, there’s an upfront rate of 0.01% of your loan amount and an annual MIP rate of 0.55%.
How Long Does MIP Last?
Unfortunately, if you purchased or refinanced with an FHA loan on or after June 3, 2013 and you had a down payment of less than 10%, MIP lasts for the term of the loan. With down payments of 10% or more, you still have to pay MIP for 11 years.
If you haven’t purchased or refinanced with an FHA loan since June 3, 2013, the outlook is a little better. On a 15-year term, MIP is canceled when your LTV reaches 78%. For longer terms, the LTV requirement remains the same and you have to pay MIP for at least 5 years.
There’s one other way to stop paying these premiums if you’re currently in an FHA loan. Assuming you meet the other qualification factors (e.g. at least a 620 median FICO® score), you can refinance into a conventional loan and request mortgage insurance removal once you reach 20% equity in your home.
PMI Vs. Guarantee Fees
Another mortgage option, a USDA loan, requires the borrower to pay a guarantee fee, which is similar to, but distinct from, mortgage insurance. USDA loans help reduce the cost for home buyers living in rural areas and in some suburban areas. As with FHA loans, rates are set by the government, but USDA rates are generally lower.
At this time, Rocket Mortgage® doesn’t offer USDA loans.
How Do Guarantee Fees Work?
Like the FHA’s mortgage insurance premium, guarantee fees are due upfront and annually. The upfront guarantee fee is 1% of your loan amount, either paid at closing or refinanced into the loan. The annual premium is equal to 0.35% of the average unpaid mortgage balance based on the original amortization schedule without making any extra payments, broken into 12 equal installments and paid month to month.
How Long Do Guarantee Fees Last?
The downside here is that guarantee fees live for the life of the loan. The only way to get rid of them is by refinancing into a conventional loan and requesting PMI removal after you reach 20% equity.
This isn’t common, but there are cases in which you can receive your loan directly from the USDA. In these instances, there are no guarantee fees.
Are There Any Benefits To Paying PMI As A Borrower?
Although PMI is for the protection of the lender and not the borrower, that’s not to say there aren’t some indirect benefits for the borrower. There are two big ones that we’ll go over here:
- PMI enables a lower down payment: Because PMI offsets some of the risk for lenders in the event that the borrower defaults, it enables down payments as low as 3%. Without PMI, you would need a minimum of a 20% down payment for a conventional loan. PMI allows you to accomplish homeownership faster.
- PMI is tax deductible: Congress has extended the mortgage insurance tax deduction through the 2020 tax year, so if you haven’t filed your taxes yet, this is still deductible. You report it along with your deductible mortgage interest from the Form 1098 you should have received from your mortgage servicer.
Even if you have the money for a 20% down payment, it may make sense to make a smaller down payment and opt for PMI depending on your financial situation and your other goals. It’s not necessarily a good idea to empty your savings.
How To Stop Paying PMI
PMI is easier to remove than MIP and guarantee fees. Typically, PMI is eligible for cancellation once the LTV on the original loan is 80% or less. By law, it must be removed once the home’s LTV reaches 78% based on the original payment schedule at closing, depending on the occupancy and unit type.
If the residence is a single-family primary home or second home, your mortgage insurance will be canceled automatically in one of the following scenarios (whichever happens first):
- The LTV on your property reaches 78%, which means you’ve earned 22% equity in your home based on the original amortization schedule (and you didn’t make extra payments to get it there).
- You reach the midpoint of your mortgage term (year 15 on a 30-year mortgage, for example).
If you have a multi-unit primary residence or investment property, these rules differ slightly. With Fannie Mae, mortgage insurance goes away on its own halfway through the loan term. By contrast, Freddie Mac does not auto-cancel mortgage insurance.
Early Payment Cancellation
If you don’t want to wait for your PMI to auto-cancel, you can request cancellation in either of these scenarios once your LTV reaches 80% through payments. The Homeowner's Protection Act requires that these requests be delivered in writing. Yeah, like many laws, it’s archaic.
Fannie Mae and Freddie Mac both allow you to make extra payments in order to get to 80% sooner. If you don’t know whether your conventional loan is held by these institutions, you can use these lookup tools from Fannie Mae and Freddie Mac.
In most cases, you’ll have to get a new appraisal in order to verify that your home didn’t lose value since closing. If you’ve made substantial home improvements to increase your property value, these will have to be called out specifically in the new appraisal.
Natural Value Increase Cancellation
If you’re requesting removal of your PMI based on natural increases in your property value 2 – 5 years after your loan closes, both Fannie Mae and Freddie Mac require a new appraisal, and the LTV has to be 75% or less. If your removal request comes more than 5 years after your closing, the LTV can be 80% or less with a new appraisal. These requirements apply to insurance removal based on market value increases not related to home improvements.
On a multi-unit residence or investment property, you can cancel PMI on your own when LTV reaches 70% based on the original value with Fannie Mae. Freddie Mac requires 65% for cancellation. Keep in mind that if you’re requesting removal based on home improvements from Fannie Mae, you must have had the loan for at least 2 years prior to requesting PMI removal on your investment property.
PMI Removal Example
Let’s say you take out a loan for a home for $150,000 and you make a $15,000 down payment. As a result, you end up borrowing $135,000 to cover the remaining cost. Dividing the amount you borrow by the value of your home gives you an LTV of 90%:
$135,000 / $150,000 = 0.9
0.9 x 100 = 90%
In the case above, once the loan has a remaining principal amount of $120,000, the LTV will reach 80% and may be eligible for PMI removal.
Avoid Mortgage Insurance From The Start
In addition to cancelling PMI, it's also possible to completely avoid paying mortgage insurance from the start of your loan. Here's how to eliminate the need for extra monthly payments.
Make A 20% Down Payment
The easiest way to skip PMI from the start is to make a large down payment. By making a 20% down payment on a conventional loan, your LTV will automatically be 80%, allowing you to pay your loan without mortgage insurance.
If Eligible – Get A VA Loan
Among all of the loan types available, VA loans are the only type that doesn’t require mortgage insurance regardless of your down payment. Instead, borrowers are required to pay an upfront funding fee. This fee helps to offset the cost of administering the loan. This helps to ensure that VA loans continue to require no down payment and no monthly mortgage insurance.
A few types of clients are exempt from the VA funding fee:
- Anyone currently receiving VA disability payments
- Eligible surviving spouses receiving Dependency Indemnity Compensation (DIC) benefits
- Active-duty Purple Heart recipients
Skip Monthly Premiums With PMI Advantage
Another option worth considering is PMI Advantage. Rocket Mortgage® allows you to buy a home without having to put 20% down and without having to pay a monthly mortgage insurance payment. With PMI Advantage, you’ll accept a slightly higher mortgage rate and eliminate monthly mortgage insurance payments. While this option still requires PMI on your home, it removes the monthly premium that you would otherwise have to pay.
If you still have questions, we're here to help! Reach out to one of our Home Loan Experts to discuss your loan options.