There are a whole bunch of new terms you'll hear when you decide to start shopping for your first home. One you may have heard of is Private Mortgage Insurance (PMI). Here's what you need to know about PMI and how it can help you buy a home.
PMI stands for Private Mortgage Insurance. It's an insurance policy purchased by you as protection for the lender on your mortgage. Loans from FHA have their own mortgage insurance (MIP). Private mortgage insurance (PMI) applies to other mortgage products and is provided through a private corporation. This insurance helps the lender recoup their losses in the event you default on the loan and the property goes into foreclosure.
Not all mortgages require PMI. Lenders generally require it when they agree to finance a home purchase with a smaller down payment (less than 20%) or for buyers with lower credit scores. It may also be required to refinance a home with less than 20% equity.
Buyers with lower down payments have to take out bigger loans, which means the lender stands to lose more if the property goes into foreclosure. It can take a bit to build some equity in your home. If you default on the loan early on, you would have fewer options to remedy the situation, increasing the chances of foreclosure. Mortgage insurance helps offset some of the financial risks and protects the lender if the worst happens.
Home buyers pay a premium for PMI coverage, same as if you purchase any other insurance. The premium is usually paid as part of your monthly mortgage payment. Some companies may allow you to make a large payment at closing to pay for your coverage. Or you may be able to include it in your loan. Paying PMI upfront can save you money over the long term. If payment is rolled into the loan, it increases the cost of the loan and the amount you're paying interest on. It saves you money at closing but may increase your costs long term. You need to figure out what makes sense for your situation and consider how quickly you're likely to build equity in your home.
The exact amount depends on your credit score and down payment, but premiums are between .3% and 1.5% of the original loan value per year. That translates to roughly $300 to $1,500 per year for every $100,000 you borrow. It is not a permanent cost. Buyers can ask to cancel PMI once you build up 20% equity in your home. Lenders are required to cancel it automatically at 22%.
You can avoid paying PMI, but whether you should depends on your situation. Some people don't like the idea of paying for insurance that benefits the lender. But PMI is a benefit for buyers too. You're able to purchase a home now, with a smaller down payment and begin building financial security. Housing costs have increased over the long term. If you are in a hot market, will be making major improvements to your home, or will be aggressively paying down your mortgage, your equity may increase faster than you think. That means the amount you pay in mortgage insurance may be minimal compared to the wealth you can accumulate by building equity in your home over the same amount of time.