Private Mortgage Insurance is an often misunderstood topic. Admittedly, the subject is not riveting. But, it is very important that those who purchase Private Mortgage Insurance (PMI) fully understand their obligations and options. Comprehension can help homeowners avoid paying unnecessary fees.
Additionally this is a topic only relevant to those who are unable to make a 20% or more down payment when purchasing a home. The world of personal finance seems to disproportionately address topics relevant for wealthier and/or older individuals while ignoring those with less money. One of my primary goals as a financial planner is to change that.
The Risk of Mortgage Default
Often home-ownership is a life goal and can bring great feelings of accomplishment. Clearly most people who buy a home are motivated to keep them. But there are certainly situations in which owning a home becomes a greater liability than the homeowners foresaw. For example, in 2008-2009 we saw home values drop so drastically that many owed hundreds of thousands of dollars more than the resale value of their home. At other times, folks may have a change in their financial situation and find themselves unable to make mortgage payments.
In addition to the desire for home-ownership, people are deterred from walking away because defaulting on a loan will substantially reduce their credit score. Persons who have invested a sizable lump sum of money into their home will further be further dissuaded from defaulting because they don’t wish to lose their deposit. These factors are considered by banks/lenders consider when they are deciding if they should give someone a loan.
Home Down Payments
A standard down payment, or money due upfront when purchasing a home, is 20% of the purchase price. Those who make a smaller down payment have less financial incentive to try to try to hang on to their house when faced with financial challenges. Also, a smaller down payment means larger monthly mortgage payments and/or a longer term for the loan.
What is Private Mortgage Insurance?
With housing prices being so high in many parts of the country, making a 20% down payment makes home-ownership out of reach for many people. This is where PMI, or Private Mortgage Insurance, comes in.
When a lender approves a mortgage for someone who has a down payment of less than 20%, they will require the borrower to purchase private mortgage insurance. This reduces the risk to the lender than the home buyer will default on the loan.
Who Benefits from Private Mortgage Insurance?
To be clear, although the buyer pays for the mortgage insurance, PMI protects the lender not the buyer. The lender is protected against default by the buyer. The buyer still risks their credit score and even the home itself if they fall behind on their payments.
Mortgage insurance is expensive. According to Next Advisor, “you can expect PMI to cost between 0.58% to 1.86% of the loan.” That means that a homeowner with mortgage insurance will be paying an extra $580-1,860 annually for every $100,000 they borrow.
Because PMI is a type of insurance, the payments are called “premiums” (the term used for the payments made to insurance companies for the purchase of insurance policies.) Most commonly, PMI payments are made monthly along with the mortgage payments. It is also possible for the premium to be charged up front.
Removing private Mortgage Insurance
The only benefit of PMI to the borrower is that it enables them to obtain a mortgage. Because of the expense, it is in the borrower’s best interest to drop the insurance as soon as possible. But, how soon are you allowed to drop it?
This essay was prompted by my witnessing individuals needlessly paying mortgage insurance. Homeowners will want to stop paying PMI as soon as they can, but it is in the best interest of the lender if the borrower continues to pay.
This is a situation in which it is important for consumers to be aware of the rules so than they can advocate for themselves.
The Federal Homeowners Protection Act
For loans taken after July of 1999, the federal Homeowners Protection Act (HPA) requires the lender to cancel the mortgage insurance as soon as the outstanding mortgage reaches 78% of the home’s original value. For example, if you purchased a home in 2012 for $500,000 and made a 10% down payment of $50,000 you would have taken a mortgage of $450,000. When your mortgage balance gets down to 78% of the purchase price ($500,000), or $390,000 then the mortgage company will automatically discontinue the PMI.
This law is great in that it means people won’t continue to pay PMI forever because they don’t know better. But there are many instances when people can cancel the PMI insurance even sooner. The 78% rule dictates the latest date by which the mortgage company must drop the insurance.
PMI is only required if you have less than 20% equity in your home. In the example provided above, the homeowner would have 20% equity in their home when their mortgage was down to $400,000. So, although the PMI would not be canceled automatically when the loan reaches $400,000, the homeowner can request the cancellation at that time.
The Effect on PMI of Rising Home Prices
In areas in which housing prices are rising rapidly you may find that you cross the 20% equity threshold sooner than you expected.
The HPA requirement is based upon the purchase price of the house. But the need for mortgage insurance is actually tied to the current value of the home. When your house goes up in value, the gain is all attributed to your equity, your mortgage balance is unaffected by the property value.
If the home purchased for $500,000 raises in value to $600,000, then the initial mortgage of $450,000 would be less than 80% of the current home value. This means the homeowner would be able to remove the mortgage insurance.
Acting on this Knowledge
Now that you have slogged through this rather dense and factual article, what does it mean for you?
First, check your mortgage statement to see if you are making PMI or mortgage insurance payments as part of your monthly mortgage payment. If so, also check your statement for your outstanding mortgage balance.
Next, check out the approximate value of your home on a home appraisal site such as Zillow, Redfin, or Trulia. Be aware that the actual market value of the home is often substantially higher than the appraised value provided on your property tax statement. When considering your mortgage, the bank will be looking at the market value rather than the value used for tax assessment.
Calculate the amount of equity you have in your house by subtracting the outstanding mortgage from the estimated market value of the home. Is your home equity more than 20% of your home value? If so, you may be able to ditch your PMI.
If you believe you believe you are eligible to cancel your mortgage insurance start by contacting the mortgage company. Ask what the process is and what documentation you will need to make this change. Some lenders may require that you have a professional assessment done. You will have to pay several hundred dollars for the assessment, but you may save even more in the long term by canceling the PMI.
Prospective Buyers
Prospective homeowners should also be aware of the rules regarding PMI. Before signing a mortgage ask for details about your PMI including how much you will be paying and the circumstances under which it may be removed. Those looking to purchase a home with less than 20% down should be aware of this extra expense they will be incurring.
With rising mortgage rates leading to a drop in housing prices in many areas I realize that my timing with this piece is less than stellar. Still, housing prices generally go up with time (depending upon the area) so unless the rules around mortgage insurance change this is information that everyone with a mortgage may benefit from.