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When you set out to buy a home, you will be buying something that will most likely become one of the most significant assets in your personal asset portfolio.
With so much of your net worth tied up in your home, it would be incumbent on you to consider taking whatever steps you can to protect your asset and underlying investment.
For beginners, you'll certainly want to purchase a homeowners insurance policy to protect the home's structure and contents against natural disasters (tornados, hurricanes, earthquakes, etc.) and fires/floods.
Homeowners' insurance is directed at protecting you and your investment.
What you might not think about is that your lender also has an investment in your home. It sits in the form of the mortgage they hold against the title of the property.
If something were to happen to destroy the home and its value, your lender would theoretically be holding a mortgage on a piece of property worth significantly less than the money they are owed.
That's not a risk that lenders like to take should you decide to walk away from the damaged property instead of repairing it.
Secondarily, the lender is always at risk of you not making your mortgage payments despite your best intentions.
Lenders aren't very fond of taking that risk either if they can't claim at least 20% equity in the property from foreclosure. Yes, most lenders are risk-averse.
For the protection of your lender, you might have the option of purchasing private mortgage insurance or a PMI policy.
In fact, your lender might require that you purchase a PMI policy as a condition of mortgage approval.
In the eyes of a mortgage lender, this protects them against property value loss or you defaulting on your mortgage payments.
This is a topic worthy of further discussion.
Who Purchases PMI?
PMI is only available to customers under certain circumstances. Only borrowers with a conventional loan or non-government loan are eligible to purchase a PMI policy.
For what it's worth, FHA and USDA loans (government-backed loans) are subject to other mortgage insurance requirements, while VA loans don't typically call for any type of mortgage insurance.
While requirements might vary slightly from one lender to the next, most conventional mortgage lenders backed by either Fannie Mae or Freddie Mac require the buyer to secure a PMI policy with a down payment of less than 20%.
Should the value of the home rise enough or the principal amount of the loan drop enough to give the home a value greater than 80% of the mortgage balance, the need to carry PMI could be dismissed.
Note: Some mortgages are written where the lender will automatically drop the PMI requirement when the loan balance is scheduled to reach 78% LTV based on the loan's amortization schedule. Otherwise, borrowers can contact their lender and request the removal of the PMI requirement when appropriate.
While it's not recommended, you can purchase PMI even if your home value drops below the 80% LTV (Loan To Value) threshold.
Since PMI could be rather expensive, it's not common for homeowners to buy a PMI policy unless they have to abide by lender requirements.
Paying for PMI
If you do have to purchase PMI, how much it will cost you depends on a few factors such as the home's purchase price, the mortgage amount and the loan term, your downpayment amount, and your credit score.
There are two general ways you can pay the mortgage insurance premiums.
The first way would be to pay a single premium before or at closing along with your other closing costs.
You can do that in cash, or you might have the option of buying the policy and having the lender roll it into the final loan amount.
The second way would be to agree to a convenient monthly payment plan.
Should you choose to go with the monthly premium option, your lender would very likely take on the responsibility of making the payment on your behalf while collecting the annual cost from you with each monthly mortgage payment.
Most homebuyers choose to pay each month because it makes it easier to drop the policy should their home drop below the 80% LTV threshold.
Does It Ever Make Sense to Pay PMI?
Setting aside lender requirements, let's suppose for a moment that you have the option of whether or not to secure a PMI policy. When would it make sense for you to do that?
There are two good reasons you might want to accept the extra cost related to PMI.
1. To Preserve Your Cash
In a robust real estate market where prices are trending higher, the need for PMI might be temporary.
In such cases, you might want to think about preserving your cash assets by going with a lower down payment amount to purchase a home.
By preserving your cash, it might open up the possibility of other investments or uses of the extra money.
Here's a practical example.
Let's say you want to purchase a home with an appraised value of $200,000 using a 30-year mortgage.
To avoid PMI, you would have to put down at least $40,000.
Instead, you decide you'll accept the PMI requirement and go with a down payment of $20,000 (10%) for a conventional mortgage loan because you have other uses for the remaining $20,000.
Since PMI runs about 1% of the loan value per year at the high end, your PMI exposure for the first couple of years per year would be approximately $1,800 with a 10% down payment. That would add roughly $150 to your monthly payments.
If your home's appraisal value in a strong market were to increase 15% over those two years, the PMI requirement could be dropped.
You would be out of pocket for $3,600 in PMI payments, but you kept $20,000 in your pocket for other investments or uses. Invested at a meager 3%, you would actually realize a gain in net worth.
2. To Enhance the Chances of Qualifying for a Home Purchase and Loan
Try as you may, it might be impossible for you to save enough money for a 20% down payment on a reasonably priced home. And when the average mortgage interest rate rises, it becomes even more challenging.
That can be very frustrating when you know you can handle mortgage payments, but the lack of an adequate down payment keeps you out of the home buying market.
Good news! If you can cover mortgage payments (according to the lender and your budget) and are willing to pay the PMI, it could open the door for you to move forward and buy a home commensurate with the amount of down payment you can make at a competitive mortgage rate.
The lender feels protected, and you get the chance to move into the ranks of a homeowner.
Is There a Way to Avoid PMI With a Down Payment of Less Than 20%?
The answer is yes, it is possible. Known as “piggybacking,” the process would require you to use two lenders to finance one home.
The first lender would lend you 80% or less of the home's value. That keeps their exposure below the 80% LTV threshold.
A second lender would come in to lend the remaining portion minus whatever down payment you wished to contribute. Theoretically, the proceeds for the second loan would pay the deposit requirement on the first loan.
The downside to piggyback loans is the second lender would likely charge a high-interest rate for their risk.
This could mean hundreds of dollars more paid out in the long run. You'd need to do the math for the various loan options to determine if you'd pay more in interest or PMI.
PMI comes at a cost, but it may also afford you the ability to become a homeowner sooner than later.
Do the math, then weigh the pros and cons of paying PMI so you can make an educated decision about whether it is right for you.