What is PMI and When Can You Stop Paying It?
Understanding Private Mortgage Insurance (PMI)
If you are like many people who are setting off to purchase a home, you may not have a ton of money to put down on said investment. First-time home buyers and folks with limited incomes often fall into this category, and it is nothing to be ashamed of.
Typically, a traditional 30-year fixed-rate mortgage requires a buyer to put down 20% of the cost of their new home to be credited toward the purchase price. However, lenders understand that plenty of people simply cannot afford that high of a percentage, even on a lower-priced home. That is why there are a multitude of mortgage programs out there that can save a buyer literally tens of thousands of dollars in down payment money. Sounds great, right?! It actually is pretty great, but remember, everything comes at a price.
Here is an example:
Pretend you are a lender, and you have a buyer who has agreed to pay $250,000 for a home. If that buyer could put down 20%, the amount would be $50,000. But wait, your buyer is approved for one of your 3% down FHA loans. Now that $50,000 has just dropped to $7,500. . . Since people are less likely to default on payments when they have more money invested in a purchase, which seems riskier to you?
Ok, now pretend you are a buyer. If you are putting less than 20% down on a home, lenders require you pay something called Private Mortgage Insurance (PMI) to offset their risk. This insurance policy protects them in case you, the buyer, default on your home loan. PMI rates can range from around 0.3% to 1.2% of your mortgage loan depending on factors including but not limited to: Your credit score, size of down payment, and local market conditions. It can become a significant chunk of your monthly mortgage payment.
The good news for you:
There is light at the end of the tunnel. While you may not be able to get around it, you also don’t have to pay it forever. So when can you stop paying it? Basically once you build up 20-22% equity. If you purchased your home after 1999, your lender is required to automatically cancel your PMI once you’ve reached a 0.78 loan-to-value ratio. In other words, once you’ve built up 22% equity. If you don’t want to wait, you can also formally request your lender cancel your PMI once you’ve reached 20% equity, although this may take several weeks and your lender is not required to oblige your request. You would also need to pay out of pocket for an additional home appraisal. But do the math and see if this option is best for you.
You may be asking, “Um, how do I do the math?” Just divide the outstanding amount of your loan by the purchase price. If you have a $235,000 balance on your $250,000 mortgage loan, your LTV is 94%. You have to get your outstanding mortgage down to $195,000 in order to be at 22% LTV, which would be an automatic cancellation. Or you can get your outstanding mortgage down to $200,000 to be at 20% LTV, which is where you can petition your lender to cancel the insurance.
As long as your adjusted gross income is less than $100,000, PMI is fully tax deductible, at least for tax year 2016. Unfortunately, the deduction lowers for people with an AGI of over $100,000 and phases out completely as your income rises.
Possible options to navigate around PMI
Now, I would be remiss if I didn’t tell you about some loopholes that could allow you to avoid paying PMI altogether. One thing you can do is take out what is called a piggyback loan when you purchase your home. A piggyback loan is created by taking out two separate mortgage loans on the same home at the same time. Your lender typically finances 80% and then gives you a second loan for 10% and you put 10% down. This is known as an 80/10/10. There are also 80/5/15’s and 80/15/5’s. Believe it or not, splitting up loans this way actually eliminates the PMI requirement.
Take heed though, this type of loan is not for everybody. There is a possibility that piggybacking might end up costing you more. Some notable drawbacks are that the interest rate on the second mortgage is higher and can end up costing more than the PMI premiums themselves. Also, since you are taking out two loans you will have two sets of closing costs instead of one. Oh, and you need to have very good credit in order to obtain a piggyback in the first place.
Another option would be to add a room, which increases your home’s market value. You can then ask your lender to recalculate your LTV ratio. It costs money and it’s a gamble, but if building an addition was something you were planning on doing, it could be worth it.
If you have lived in your home for several years and it has increased in value (which it is technically supposed to), you can refinance. If the value has increased enough, the lender will no longer require PMI.
A special exception
Lastly, if you qualify for a Veteran’s Administration (VA) loan, you are exempt from having to pay PMI.
I hope I have helped you understand the fundamentals. Home buying can be overwhelming at times, and that is why you should have a trusted real estate agent to help you navigate your way through. If you or someone you know is thinking of buying a home in northern New Jersey, please give me a call. I am happy to help!