Why you're stuck paying mortgage insurance
Welcome to the one insurance policy you can't shop for, don't benefit from, but will have to pay if you don't have a big enough down payment.
This post comes from Kentin Waits at partner site Money Talks News.
But that's not true with one common type of insurance: mortgage insurance. You'll pay the premiums, but you have no ability to shop for the best deal, nor will you benefit if things go south. It's your lender who makes you buy it, tells you who to buy it from and collects all the benefits if something goes wrong.
Contrary to what some believe, mortgage insurance doesn't make payments on your behalf if you can't. Instead, it protects the lender -- not you -- in the event of a default. Mortgage insurance is typically required for any borrower putting down less than 20% when purchasing a home.
The details about the cost of mortgage insurance and when it can be dropped can be confusing. While conditions differ depending upon the type and terms of your loan, here are some general guidelines.
Two types of mortgage insurance
Mortgage insurance is generally either purchased from the Federal Housing Administration or bought privately. For buyers with FHA loans, the U.S. government collects the premium and guarantees the loan. For conventional loans, private mortgage insurance, or PMI, is underwritten by a private company.
When it's required
For a conventional home loan, buyers can ask the lender to drop PMI whenever their loan-to-value (or LTV) ratio reaches 80% and the equity equals 20%.
To illustrate, if you buy a home that costs $100,000 and put down $20,000, you've got an 80% loan-to-value and 20% equity: no PMI required. Put down just $10,000, however, and you have a 90% loan-to-value and only 10% equity: PMI required.
Paying down the mortgage until it reaches $80,000 will give you 20% equity, but appreciation could also do the trick. If our sample house becomes worth $120,000, for example, even if the mortgage is still $90,000, it would have a loan-to-value ratio of 75% ($90,000 divided by $120,000 = 75%) and equity of 25%. PMI can now be canceled.
There's also a situation where the lender must automatically cancel the policy, with no action by you. Says mortgage insurer MGIC, it's:
On the date the mortgage loan balance is first scheduled to reach 78% of original value, based solely on the initial amortization schedule, regardless of the outstanding loan balance AND
The borrowers are current on the payments required by the terms of the mortgage.
For FHA loans with a case number assigned after June 1 of this year, mortgage insurance is required for the life of the loan, regardless of LTV ratios. This means FHA borrowers who don't put down 20% are effectively paying a "low down payment tax."
The only way out of PMI in those cases is to refinance the house with more than 20% equity.
How much does it cost?
Private mortgage insurance rates can vary based upon the down payment and the buyer's creditworthiness. Premiums usually range from 0.03% to 1.5% of the original loan amount each and every year, Bankrate says. PMI premiums are baked into monthly mortgage payments. The premiums for FHA-insured loans are set by the federal government.
For buyers who've struggled to save a down payment in the first place, monthly mortgage insurance premiums can often stress budgets that are already stretched a bit thin, so it helps to have a clear idea of costs. For an easy-to-use mortgage calculator that includes PMI premiums, check out this estimator by CNNMoney.
Using the example above, if we put $10,000 down on a $100,000 house, CNNMoney's calculator says our PMI would be $80 per month.
You might be able to deduct it
PMI premiums are tax-deductible in these situations through 2013, says Houselogic:
You got your loan in 2007 or later.
Your mortgage is for your primary residence or a second home that's not a rental property.
Your adjusted gross income is no more than $109,000. The deduction begins to phase out once your adjusted gross income (AGI) exceeds $100,000 ($50,000 for married filing separately) and disappears entirely at an AGI of more than $109,000 ($54,500 for married filing separately).
How to avoid PMI
It's simple: Put up at least 20% of the purchases price of your home.
Another route is to get what's called a piggyback loan in addition to your first mortgage, so that your down payment and the second loan add up to 20% of the purchase price. However, Investopedia warns:
Of course, there is a catch. Very often the terms of the piggyback loan are risky. Many are adjustable-rate loans, may contain balloon provisions, and are due in 15 or 20 years (as opposed to more conventional loans which are due in 30 years).
Getting a piggyback loan also typically requires excellent credit.
Sunsetting your PMI
Discontinuing PMI can get sticky. Federal law requires non-FHA lenders to automatically cancel PMI premiums when a borrower's balance reaches 78% LTV as determined by the loan's amortization schedule. But you can also ask your lender to drop PMI when you've reached the 80% LTV mark. As mentioned above, this can happen with a combination of events:
- You make extra payments on the principal.
- Your house goes up in value, either because of market trends or improvements you've made. "Consider getting an appraisal of your property if either of these causes your home's loan-to-value ratio to drop significantly," Realtor.com says.
PMI pros and cons
The advantage of PMI is straightforward: Buyers are able to seize a homebuying opportunity they may have otherwise missed by waiting until they'd saved a 20% down payment.
The cons? In addition to the extra cost, where payments aren't automatically canceled, failing to act means premiums could roll on month after month, year after year, and end up wasting thousands.
And canceling PMI before the mortgage amortization reaches 78% means jumping through hoops. For example, if your equity increases through a rising market or improvements to your home, you'll have to prove it by paying for an appraisal, then filling out any forms required by your lender. Many don't make the process easy.
The bottom line
If you're planning to purchase with less than 20% down, understand how PMI works, what you'll pay, and the requirements to make it stop. Explore piggyback loans, and compare the added interest you'll pay on a second loan with the cost of PMI.
And don't feel too bad about paying for a policy you don't get to shop for and get no protection from. Because it reduces lender risk, mortgage insurance is the only way many dreamers become owners.
Karen Datko and Stacy Johnson contributed to this post.
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