You may have heard the “rule” that you have to put 20% as a down payment when buying a house. In reality, most home buyers — especially most first-time home buyers — are putting down much less than this. While you can now get into a new home for as little as 3% down, you may end up paying private mortgage insurance (PMI).
If you’re planning to purchase a home in the near future, it’s important that you understand what PMI is and how much it could cost you when budgeting for a house purchase.
What is private mortgage insurance?
What is PMI? Private mortgage insurance (PMI) refers to an insurance policy designed to protect the lender in the event you default on your home loan. Most lenders require PMI when your loan-to-value ratio is 20% or lower. In other words, if you put down less than 20% as a down payment, most lenders will require PMI.
The idea is that buyers who don’t have at least 20% to put down on their new home purchase might be riskier borrowers. Whether you have an excellent credit score or are trying to buy a home with less than perfect credit, lenders require this as added protection. While the policy is designed to protect the lender, the buyer will pay the premium.
Should you get private mortgage insurance?
Well, avoiding PMI may not be possible depending on your availability of liquid cash when purchasing a home and your lender’s requirements. However, you do want to avoid private mortgage insurance when at all possible for a few reasons:
- It can be expensive. PMI can add several hundred dollars onto your mortgage payment every single month, making that loan a lot less affordable than you initially thought.
- It protects the lender, not you. While other forms of insurance you may have protect you, PMI only protects the lender. The only benefit to you is that it allows you to secure a home loan with less than 20% down.
How expensive is PMI?
PMI can be paid in three different ways — as a monthly premium, a one-time up-front premium or as a combination of the two. Costs will vary based on your credit score, the size of your loan, the loan-to-value ratio, how many borrowers on the loan, your mortgage loan rate and the type of home you are buying — single-family, investment property, corporate relocation, second home, etc. Additionally, shorter loan terms like 10-year and 15-year mortgages may qualify for a discount or no PMI with some lenders.
Monthly premiums can range anywhere from less than 1% of the total loan up to 5% or more of the total loan value.
For example, let’s say your PMI rate is 1% on a $400,000 home that you put 3% ($12,000) down on. Your total loan is $380,000, because $400,000 – $12,000 = $380,000.
1% of the total loan ($380,000) is 0.01 x $380,000 = $3,800. The cost of your PMI for the year would be $3,800. Divide that by 12 months and you get your monthly PMI premium of $316.67. This is a simplified example, as many of the aforementioned factors play into determining the exact PMI rate.
Is PMI tax deductible?
PMI was tax deductible until 2017 when the tax break expired. However, in 2019, the IRS moved to reenact the tax break for 2019, 2020 and retroactively for 2018. For years 2019 and 2020, homeowners looking to take advantage of the tax break will need to file Form 1098 with the IRS.
How to cancel PMI
The good news is that PMI does not last forever. You can request your PMI be removed when your loan-to-value ratio reaches 18%. However, there is no guarantee that your lender is going to approve this. Additionally, you can request a reappraisal of your home if you believe it has greatly appreciated in value. A higher-valued home would bring the loan-to-value ratio down as well. You may have to use an appraiser appointed by the mortgage lender, and this may not be an easy process.
Your other option is to wait until your loan-to-value (LTV) ratio reaches 22%. At this point, PMI is required to come off. Here’s a complete list of the ways to cancel PMI.
- Wait for PMI to be auto-canceled at 22% LTV.
- Request an early cancellation at 18% LTV. Remember, your lender is not required to honor this.
- Request an appraisal when you believe your home has appreciated enough to change your LTV to over 22%.
- Make additional payments to your principal to get to the 22% LTV ratio quicker.
- Avoid PMI in the first place. Options may include waiting to buy, purchasing a less expensive home, getting a shorter-term mortgage or a mortgage with a higher interest rate.
Avoiding private mortgage insurance
PMI protects the lender and not you, so it’s not up to you whether you get PMI or not. If the lender requires it, you’ll need it to secure the loan. The bigger question becomes if you should purchase a home that requires PMI.
The answer depends on your financial situation, whether you can afford the larger payments and how far away from a 20% down payment you are. You can save a lot of money if you’re able to wait until you have an adequate down payment to buy. Or, you can opt for a less expensive home that allows you to afford a 20% down payment.
The bottom line
There are two main takeaways to remember about private mortgage insurance. First, remember that PMI is designed to protect the lender and not you. Second, remember that PMI can be expensive and needs to be calculated into your budget before making a home purchase.
While neither of these details is ideal, PMI may give you the ability to purchase a home when you wouldn’t otherwise have the opportunity. If the cost is worth the reward and you can afford the larger payments, it may work in your favor.