What is Private Mortgage Insurance, How Does It Work and When Can I Remove It From My Loan?
Private Mortgage Insurance, often referred to as PMI, is a form of insurance that protects the lender in the event that the borrower stops making payments on their loan. More specifically, if the borrower defaults, the mortgage insurer reduces or eliminates the loss to the lender, meaning that the lender is the sole beneficiary of the policy.
Typically, lenders will require a borrower to purchase PMI if their down payment is less than 20% of the sales price or appraised value of the home. Even though PMI exists for the protection of the lender, it is the borrower that pays the premiums for this insurance policy.
So, what’s in it for the borrower? The simple answer is that the borrower is able to obtain a loan and purchase a home for less than 20% down. As is evident, lenders take a risk whenever loaning large sums of money. The less the down payment, the greater the risk. Rather than simply refuse to approve loans with less than 20% down, PMI helps protect the lender, thereby incentivizing the lender to loan money even when the borrower makes a small down payment.
Because of the expense associated with Private Mortgage Insurance, which typically costs between 0.5% to 1% of the entire loan amount on an annual basis, borrowers are often eager to remove this financial obligation as soon as possible.
Pursuant to the Homeowner’s Protection Act, borrowers have the right to request, in writing, that the lender cancel the PMI once the principal balance of the mortgage falls to 80% of the value of the home. This date should be provided to the borrower in writing on a PMI disclosure form at the time the mortgage is secured.
Regardless, an increase in the home’s value from the time it was initially appraised may enable the borrower to more quickly cancel their PMI obligation. Borrowers may therefore choose to obtain a more recent appraisal of the home to prove to the lender that the home’s loan-to-value ratio is 80% or lower.
Even if a borrower fails to ask the lender to cancel the PMI, the lender is required by law to automatically do so once the borrower pays down the mortgage to 78% of the principal. However, the borrower must be current with their monthly payments before any lender is obligated to cancel the mortgage insurance.
To calculate the loan-to-value ratio, all the borrower need do is divide the current loan balance by the value of the home. For example, if a borrower owes $195,000 on a home valued at $250,000, the loan to value ratio would be 78%, meaning that the lender should terminate the PMI. ($195,000 / $250,000 = 78%)
Finally, it is worth noting that PMI is called “private” because it pertains only to private companies, not government agencies or public mortgage lenders. Public programs, such as VA and FHA, have their own mortgage insurance which is run differently and managed internally. One notable difference between PMI and the mortgage insurance attached to many VA and FHA loans is that the latter never expires. In other words, borrowers will continue paying mortgage insurance on VA and FHA loans even after the loan-to-value ratio falls below 80%.
Bottom line, a 20% down payment may prove a difficult hurdle for many consumers, especially young, first time buyers. PMI allows borrowers to overcome this hurdle, but at a cost. Fortunately, that cost is temporary.
For more information about PMI, consider the GRI course Financing: From Preparation to Closing. Tentative dates for 2016 are posted here; confirmed information will be posted on our Calendar of Events.Tags: homeowner's protection act, PMI, private mortgage insurance