If you qualify for conventional financing, but you put less than 20% down on the home, you’ll pay Private Mortgage Insurance. It’s a cost that has many would-be-buyers shuddering and it makes some avoid taking out the loan altogether.

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Is PMI as bad as people make it seem? It has its good and bad sides – keep reading to see how it may affect you.

The Benefits of Private Mortgage Insurance

PMI is an extra charge every month, but there are certain benefits that it does allow:

• You don’t need a large down payment – You can get a loan with as little as 5% down in some cases. Of course, you have to qualify with your credit score and debt ratio to prove that you can afford the loan, but if you qualify, the PMI helps you. The PMI helps lenders know that they will still receive most of the money that you borrowed even if you default. That extra charge every month gives you the boost you need for approval.
• You can buy a home sooner – Without the need to save for a 20% down payment, you can likely become a homeowner much sooner than if you needed 20% down on the home. Let’s say you wanted to buy a $200,000 home, a 20% down payment would be $40,000. If you only needed a 5% down payment, you’d only need a down payment of $10,000. Chances are that it is a lot easier to save $10,000 than $40,000.
• You can request lender paid PMI – If you don’t want the extra charge on your mortgage payment each month, you can ask for lender paid PMI. The lender will pay the total cost of the loan’s PMI upfront for you. In exchange, they charge you a slightly higher interest rate. If the extra interest charges are less than what the PMI would cost, it may make sense for you to do so.
• You can cancel PMI – You don’t have to pay PMI forever, unlike FHA and USDA loans. You can request cancellation of the insurance once you owe less than 80% of the home’s value. You have to request the cancellation, which means keeping tracking of your home’s appreciation and your outstanding principal balance. You can request cancellation in writing. If you don’t cancel at that point, the lender must cancel it automatically once you owe less than 78% of the home’s original value.

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The Downsides of Private Mortgage Insurance

There are downsides of PMI that you should know about just to make sure it’s right for you:

• PMI raises your debt-to-income ratio – You pay PMI on a monthly basis, which means it makes your mortgage payment higher. This makes your housing ratio and total debt ratio higher. Conventional loans allow a 28% housing ratio and 36% total debt ratio. If you are near that before the PMI, the Private Mortgage Insurance may set you over the limit.
• You can’t count on your home appreciating – The housing crisis taught us that home values could drop fast. If you count on canceling the PMI in a few short years, yet your home’s value drops, you won’t be able to cancel it.
• It’s an added expense – If you look at the big picture, Private Mortgage Insurance can cost you thousands of dollars on top of the actual cost of the home. Even if PMI costs you an extra $50 a month and you pay it for 10 years, that’s an extra $6,000 that you won’t see again. You don’t get reimbursed for the insurance premiums that you pay.
• The insurance is for the lender – Even though you pay the premiums for the insurance, it protects the lender. If something happens to your home or you can’t make the payments, it’s the lender that has coverage, not you. The only coverage you have is your homeowner’s insurance, which covers you in the event of a disaster that occurs to physically harm the home.

Private Mortgage Insurance has good and bad sides. Generally, it helps buyers afford the home that they want/need. Before you accept PMI, make sure you explore all of your options. Ask about the actual cost of the PMI as well. Each buyer pays a different amount as it’s based on your LTV and credit score.

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Many loans today require mortgage insurance including conventional, FHA, and USDA loans. You can only avoid mortgage insurance if you put down at least 20% on a conventional loan. All FHA and USDA loans carry mortgage insurance regardless of the amount of your down payment. Knowing how it works and what to expect can help you prepare for a mortgage.

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What is Mortgage Insurance?

If you have to pay mortgage insurance, know that it’s coverage for the lender, not you. You pay the premiums, but the protection covers the lender should you stop making your payments. Government-backed loans require the insurance in order for the FHA and USDA to guarantee the loan. The FHA and USDA don’t write or fund loans – instead, they guarantee them for the lender. This is how lenders are able to give loans with flexible guidelines, like credit scores as low as 580 or debt ratios as high as 41%.

Conventional loans require PMI or Private Mortgage Insurance if you put less than 20% down on the home. Without 20% down, you pose a higher risk of default. In order for lenders to write the loan, they want the protection of Private Mortgage Insurance. If you stop making payments, the lender will receive reimbursement from the insurance company.

How Government-Backed Mortgage Insurance Works

If you use FHA or USDA financing, you actually pay mortgage insurance twice. The first time is at the closing. You’ll see it called the upfront funding fee or upfront mortgage insurance. This money goes straight to the FHA or USDA. The FHA charges 1.75% of the loan amount upfront and the USDA charges 1% of the loan amount. You can pay the fee in cash at the closing or wrap it into your loan amount.

The FHA and USDA also charge annual mortgage insurance. The name is deceiving, though, since you pay it monthly. The lender pays the premium to the insurance company on your behalf once a year, but you pay 1/12^th of the premium each month with your mortgage payment.

Government-backed mortgage insurance lasts for the duration of the loan. If you take out a 30-year loan and you keep the loan for the entire term, you pay mortgage insurance the entire time. The only thing that differs is the amount of the premium that you pay. FHA loans, for example, charge 0.85% of the outstanding premium each year. The lender calculates your premium based on your average outstanding balance each year, as you pay the balance mortgage balance down, your premium decreases.

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How Conventional Loan Mortgage Insurance Works

Conventional loans have Private Mortgage Insurance because they aren’t backed by a government entity. The PMI comes from several different companies – each lender typically has a company they prefer to use. Each insurance company has different pricing too.

You only pay PMI if you put less than 20% down on a home, though. The amount you pay remains the same for the term you must carry it. This is where PMI differs from government-backed mortgage insurance, though. You only pay PMI until you owe less than 80% of the home’s original value. You can determine when this will occur by looking at your PMI Disclosure or amortization table.

Once you owe less than 80% of the home’s value, you can request PMI cancelation in writing. The lender will evaluate your situation and decide at that point if you qualify to cancel the insurance. Lenders look at:

• Your payment history – Do you make your payments on time?
• Your current housing history – Are you current on your payments?
• The home’s current value – Did the home’s price remain stable or appreciate?

If you make your payments on time and are current on your payments, most lenders will allow cancellation of your PMI.

If you don’t cancel the PMI once you hit the 80% point, the lender must cancel it once you owe less than 78% of the home’s original value – it’s the law.

The lender reserves the right to not cancel the insurance if your home’s value decreased or you are behind on your payments. Remember, the insurance protects the lender should you default on your loan. They take a big risk when letting the insurance go.

Getting Rid of Mortgage Insurance

Whether you have a government-backed loan or a conventional loan, there’s one way to get rid of mortgage insurance once and for all – refinance. Of course, you need all of the right pieces to fall into place.

If you have a government-backed loan and you owe less than 80% of the home’s value, you can refinance into a conventional loan. If you have a conventional loan, but have paid the balance down significantly or the home appreciated a lot, you may refinance the loan, order a new appraisal and get rid of the PMI.

Mortgage insurance seems like a nuisance, but it helps you get the financing you need. With an insurance policy in place, lenders are more likely to give you the financing you need, even if you have a high LTV or even a low credit score.

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If you put less than 20% down on your home when you bought it, you probably pay Private Mortgage Insurance as a part of your mortgage payment. If you took an FHA loan, no matter how much money you put down, you must pay mortgage insurance each month.

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You may wonder if it makes sense to refinance your loan to get out of the PMI if you have the chance. In some cases, it may make sense, but certain factors have to fall into place. Keep reading to learn if it’s right for you.

What Will it Cost?

Your first consideration should be the cost. You can’t refinance for free. So what will it cost? Do you have the money available to pay the closing costs or will you wrap the costs into your loan? This will make a difference in what you should do.

If you have the money to pay upfront, you can keep your mortgage payment down and enjoy the PMI free loan, assuming you have at least 20% equity in the home. If you wrap the costs into your loan, you increase the principal balance of your loan. This makes your payment higher. While you still might avoid PMI, you just made your loan balance higher, which means it will take longer to own the home free and clear.

What’s Your Break-Even Point?

Putting the cost aside for a second, it’s time to figure out your break-even point. It’s not enough to assume that you’ll save because you won’t pay PMI anymore. You need to know when you will start realizing those savings. This goes back to the closing costs. How long will it take you to pay back the closing costs based on the savings you’ll earn?

Here’s a quick formula that you can use:

Total closing costs/Monthly savings on new loan = Months to break even

Just how long is a ‘good amount of time’ depends on your circumstances. Typically, a break-even point of three years or less is feasible. But, that’s only if you are going to stay in it longer than three years. Let’s say that your break-even point is 3 years and you are going to move in 4 years. Does it make sense to fork over the money for closing costs just to save a little money over the course of one year? It probably doesn’t make sense.

On the other hand, if you plan to stay in the home for the foreseeable future and it will only take 3 years to pay off the closing costs, then it may make sense to do so. You have to know that break-even point as well as your plans to figure out what’s right for you.

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Can You Get the PMI AutomaticallyRemoved?

If you have a conventional loan, you should know about a little rule that conventional loans have. You are able to request that the lender remove your PMI once you owe less than 80% of the home’s value. This could be the home’s original value or the current value, if it increased. You may have to pay for an appraisal to prove the higher value of your home, but that costs peanuts compared to a full-blown refinance.

If you know that you owe less than 80% of the home’s value, you can request removal of the PMI in writing. The lender will then evaluate the situation to determine if you do in fact ow less than 80% of the home’s value.

Here’s another fun fact, though. If you don’t request that the lender remove the PMI when you owe less than 80% of the home’s value, the lender has to remove it once you owe 78% of the home’s value. It’s an automatic removal. You don’t have to request the removal in writing or prove anything. The lender must remove it on their own.

If you are close to this point, it may not make sense to pay to refinance since you can get the PMI removed free of charge. If you are happy with your current loan’s term and interest rate, it may be better to just leave the loan alone and let the PMI fall off on its own.

As you can see, every borrower has a different situation. It’s up to you to figure out which option works the best. Weigh the pros and cons of each situation to help you decide which option will leave you with the best results.

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