Private mortgage insurance, or PMI, is a nasty little drain on your personal finances. If you are paying for it, you need to get rid of PMI now!
Even though “insurance” is in the name, this monthly fee is not there to protect you if something bad happens. It is only there to protect the bank!
And you are paying for it!
Don’t Pay to Protect the Bank
One of the first rules in frugality or personal finances is to eliminate unnecessary expenses.
PMI is definitely an unnecessary expense!
Banks and lenders use PMI to protect themselves in case you end up in foreclosure. If you can’t pay your mortgage payments, the lender will sell your house. If you don’t have enough equity in the house to pay it off (ie you are underwater or the mortgage is more than the value of the house), then the bank will use their insurance policy to make up the difference.
Remember, PMI is for the lender’s benefit and not yours!
How Much PMI Costs You
PMI typically costs 0.3% to 1.5% of the original loan amount, per year. The percentage cost for PMI is based on your risk to the lender.
There are two main risk factors: the amount (or lack of) down payment and your credit score.
Why Your Down Payment Size Matters for PMI
First, on your side of the equation, the down payment affects your PMI cost. Remember, the PMI is based on the original loan amount. Would you rather pay 1% annually on $200,000 or $180,000?
Right off the top, the larger the down payment, the smaller your loan size. That means less risk to the lender and thus less cost to you to protect them.
Now, on the lender’s side, the discussion is a little more complicated. If you end up in foreclosure, the lender is likely to be made whole if you put in a large down payment. On the other hand, if you don’t have a down payment, the bank is more likely to end up losing money on the mortgage if you can’t make your monthly payments.
Let’s look at an example:
If you bought a $200,000 home today with a 10% down payment of $20,000, that’s a beginning mortgage of $180,000. If you have a 30 year conventional mortgage with an interest rate of 4.25%, after three years your mortgage balance will be $166,756. Meanwhile, if you had no down payment, the mortgage after 3 years is $185,284.
Your neighborhood of $200,000 houses hasn’t appreciated in value much, if at all, in those three years. Also, remember if you have had trouble paying your mortgage, what’s the likelihood that you have kept up on maintenance or other required repairs so that your house could quickly sell on the open market?
The lender is likely to have to sell below market price to move your house quickly. Let’s say that they take a 10% hit and sell for $180,000. Which down payment is going to cover your outstanding mortgage? If you had a 10% down payment, there would be money leftover. With no down payment, they lose money.
That’s also before things like the fees to foreclose and to sell your home.
And that’s the risk that the lender is trying to protect against.
Why Your Credit Score Matters for PMI
PMI is all about risk to the lender. If you have a good credit score, with a history of making payments on your debts, then lenders think you are less likely to default on your mortgage.
If, on the other hand, you have a lower score, with some missed payments or high debt loads, you are more likely to get in a situation where you can’t pay your monthly mortgage bill.
If you are in the lender’s shoes, who is more of a risk?
More risk = higher rates.
So not only has your lower credit score mean you get a worse interest rate, it also means you’ll get a worse rate on PMI.
Thus, credit scores are important when you are applying for a mortgage!
How to Avoid PMI
You can avoid PMI by having a 20% down payment when you buy your home.
Don’t be fooled by promises of low cost mortgages with no down payments. They are risky for the lender and you will end up paying for that risk!
What if I Can’t Put 20% Down?
So you’ve done the rent vs buy calculation and decided the right answer is to buy a house. Problem is that in your area, it’s going to take at least $150,000 (and perhaps a lot more) to find a suitable home. For a $150,000 home, that means you need $30,000 saved for a 20% down payment. And it only goes up from there.
$30,000 in savings is tough for a lot of people, especially first-time home buyers that don’t have equity from their last home to use as their down payment.
At this point, if you buy, you’ll end up with PMI. Your goal then is to make sure you have as large a down payment and credit score as possible to reduce the cost of PMI. You may also want to look at smaller, more affordable houses so that you are getting closer to the 20% mark.
Options for Getting Rid of PMI
Now that we are stuck with PMI, the goal becomes getting rid of PMI.
To get rid of PMI, we need to reduce the risk to the bank. And we do that by lowering the outstanding mortgage.
There are two common ways of getting rid of PMI:
When the loan-to-value (“LTV”) reaches 78-80% and getting rid of the loan.
When your loan reaches 80% of it’s original value, you can write to your lender to request cancellation.
Now here’s the kicker, the lender does not have to cancel the PMI. There are several requirements that must be met first.
- You must request cancellation in writing.
- You must be current on your payments and have a good payment history.
- You may have to prove that your home has not declined in value by getting an appraisal (at your cost) which can range from $300 to $800.
- You cannot have second liens on your home that reduces the equity you have (for example, a home equity loan).
Once you meet these requirements though, the lender should cancel the PMI after you request it at 80%. If for some reason that doesn’t work, or you don’t want to pay for an appraisal, you can wait until you reach 78% of the original loan value when lenders are required to cancel the PMI.
Lenders are also required to cancel PMI, even if you have not reached 78%, at the mid-point of a loan. That means if you have a 30 year conventional loan, your lender will cancel the PMI after 15 years. With a 15 year loan, the lender cancels PMI at 7.5 years.
Refinancing to get Rid of PMI
One option, particularly if you had a high interest rate at the beginning of your loan, is to refinance. If you refinance with at least 20% equity, you will not have to continue to pay PMI.
The problem is that refinancing costs money! Just like with buying your home, you have to pay closing costs – appraisals, lender’s fees, attorney’s fees, filing fees, and more! This can easily be 2-3% of your mortgage value. While you can often roll these costs into the loan, it is going to reduce to LTV or equity. Be sure that you don’t end up owing PMI again on the back end. Be prepared to pay these costs out of pocket.
If you are close to reaching the 80% mark on your original loan, the costs for refinancing might not make much sense. The costs are often higher than the costs of PMI. Make sure you do the math to figure out which is the best case scenario for you.
Refinancing is also dicey right now, with interest rates on the way up. If you have owned your home for only a few years, it’s likely that you got a really good rate with interest rates being at historical lows.
Thus, you may not be better off by refinancing just to get rid of your PMI. It works best for people that have increased their credit score and have significant appreciation on their homes, whether because of improvements you’ve made or because the market is on fire in your area.
If you have a good interest rate on your existing mortgage, it may be easier and cheaper to just pay down the existing loan value to get rid of PMI.
Avoid FHA Loans
So the news isn’t good if you take out a FHA loan though. A FHA loan backed by the Federal Housing Authority who insures the loans for your local lender. Because these loans require smaller down payments and have looser underwriting requirements, these loans represent a higher risk to the lender. Since that lender is backed by the federal government, the government wants to protect its investment. The government has passed laws that say the PMI cannot be cancelled for the life of the loan.
The only way to get rid of the insurance on a FHA loan is to pay it off, which can be through your own funds, or by refinancing it into a non-FHA loan. FHA loans also come with an upfront insurance cost of 1.75% of the loan, another expense to your housing budget.
In addition to these insurance requirements, FHA loans typically come with higher interest rates. Remember, it is mainly a function of your risk to the lender. And smaller down payments, poor credit score, and spotty employment and income history, all lead to higher interest rates. And these are budget killers!
If you can, we highly recommend that you avoid FHA loans. Work on your credit score/history and upping the size of your down payment to avoid FHA loans to reduce your housing expenses.
PMI Protects The Bank, Not You
Remember, this insurance product is not there to protect you. So why would you want to pay for it? If you can’t avoid PMI, the goal is to get rid of it as soon as possible. This will result in a $75-200 per month back into your budget!