What is Private Mortgage Insurance & How PMI Works?

what is PMI
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When you opt for a conventional mortgage on your home, your lender will ask for a down payment. This down payment must usually amount to 20% of the home’s purchase price, without which most lenders are reluctant to lend you the money.

If you insist on buying a house without paying 20% as a down payment, your lender may ask that you pay private mortgage insurance (PMI).

Private mortgage insurance (or PMI) is a type of insurance that protects the lender if you default on loan repayment. Lenders typically ask for PMI if the buyer pays less than 20% of the base price when opting for a mortgage loan.

As such, PMI isn’t a personal cover but an additional cost the lender may ask you to bear along with your loan repayment. In this article, we’ll discuss PMI in more detail and explain how it works.

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How to Pay for PMI

It’s worth mentioning that PMI isn’t meant to cover your home or any losses you incur. The sole purpose of private mortgage insurance is to protect the lender, who could lose a significant portion of their funds if you default on loan repayment. 

The existence of PMI could be beneficial to both parties as new homeowners are able to purchase their homes without having to save up to 20% of their cost price.

Additionally, lenders can protect a portion of their assets in case the home buyer defaults on repayment and the house is foreclosed.  There are three main ways to pay for PMI.

Lump sum amount

Sometimes, your lender may require that you pay the entire amount for PMI before granting you the loan. This amount is typically between 0.58% and 1.86% of your mortgage amount per year.

Your lender may ask for the lump sum at the beginning while finalizing the loan or add the amount to your closing costs.

Monthly premiums

If you’re opting for private mortgage insurance, it may be because it’s challenging to save up to 20% of the home’s cost price. If you’re in such a situation, paying the entire PMI upfront may also be challenging.

Luckily, most lenders pay the entire PMI upfront and recoup the costs by adding it to your monthly repayments. Remember that the monthly premium will include your loan amount, the interest, and an amount for PMI.

Hybrid repayment

While it’s relatively rare, some lenders will give you the option of paying a particular amount upfront and the rest through monthly premiums.

Hybrid repayments work well when you’ve got a bit of money in the initial phase but not enough to cover the entire insurance premium.

There are benefits and disadvantages to the first two kinds of PMI payment methods.

  • If you’re paying a lump sum upfront, you won’t have to worry about paying the premium every month, thus reducing your costs. However, you can’t recover this amount if you decide to move within that year.
  • Monthly premiums are ideal for those looking to spread their expenses throughout the year, but they’ll increase your monthly expenses until you pay off the insurance. 

And if you aren’t in a position to pay 20% of the home’s cost as a down payment, it’s unlikely that you’ll have enough funds to clear the insurance upfront.

In such a case, it’s best to opt for monthly premiums or a hybrid form of repayment.

3 Factors to Consider When Opting for PMI 

While it may seem like monthly premiums will drain your bank account, it’s the ideal solution to owning a house sooner in today’s booming real estate industry. 

With the average price of homes in the U.S. rising above $350,000, it’s almost unimaginable for first-time homeowners to make a 20% down payment.

PMI allows you to get your property sooner to start building wealth of your own. Here are some factors to consider if you’re using PMI to leverage a mortgage loan.

PMI doesn’t protect you

It’s worth mentioning again that PMI ensures the lender, not the buyer or the asset (in this case, a house) in question. So if you cannot pay back your loan for any reason, PMI will not protect you, and the bank can seize your home.

PMI amount depends on credit score 

The amount you’ll be charged as PMI depends on two essential factors:

  • Credit Score
  • Down Payment

A higher credit score translates to better financial stability and proves you’re adept at repaying loans. As such, your lender will charge a lower PMI if your credit score is good.

Additionally, the amount you put down in the initial phase will determine your PMI. If you’re able to put only 6%, it means the lender will have to invest the balance 96% and assume a more significant risk.

As such, they’ll opt for higher insurance coverage to offset the risk.

You can stop paying PMI

You can eventually stop paying monthly premiums on your PMI once you clear a portion of the loan. In fact, your mortgage provider is legally obligated to discontinue your monthly premiums once you return 22% of the principal amount on your loan.

You can also request your lender to cancel PMI repayments when you reach 20% equity on your home. To clarify, when you have 80% of the original loan amount, you can ask your lender to cancel any subsequent PMI payments.

With this clause built into PMI, it makes sense to opt for insurance if you’re looking to purchase a home without the required funds quickly.

Bottom Line

PMI is a tool to help new homeowners get a house without having the necessary funds. And while PMI may increase your monthly loan repayment for a while, at least you can avoid paying rent and instead invest money in your home.

As mentioned, PMI can eventually be canceled when you’ve got the right amount of equity on your home loan. So if you play your cards right and stay disciplined with repayments, PMI can effectively get you a house with little initial investment.

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