Of all the complicated processes we undertake in this life, buying a home has to be one of the most complex. Down payments, closing costs, pre-qualification vs. pre-approval ... it's a mess. One of the terms thrown into this process is PMI. It's not well-understood, but it has important implications for people who are not only trying to buy a home, but determining how much money they can put towards their goal. Today we're here to fill you in on how it works. But before we go into the details of PMI, we have to explain a term called Loan To Value ratio. Why? Because this ratio is one of the variables that determines whether or not you will have to deal with PMI in the first place.
What Is Loan To Value?
Loan To Value (LTV), put simply, is a ratio that tells you how much equity or ownership you have in your home. For example, if you have a home that is worth $100,000 and a mortgage balance of $90,000, your LTV would be 90%. This ratio means that you have paid off 10% of your home's value, which is now your equity.
Loan To Value is important when it comes to PMI because many lenders require you to have a Loan To Value rate of 80% to avoid having PMI on your home loan. This requirement gives the homeowner two options: put down at least 20% of their home value as a down payment before closing on a mortgage, or choose not to and pay down their loan after closing until they reach the 80% threshold. But unless 80% LTV is reached in some form or fashion, PMI will be added onto your loan costs. Now that you understand Loan To Value, we can dig into PMI. So what is this mysterious term people refer to, how much does it cost, and why is it so important?
What Is PMI?
PMI stands for Private Mortgage Insurance. And while it may sound like it's insurance that protects you, PMI is actually insurance that your lender takes out for themselves in case you default on your home loan. But that's not the worst part ... you have to pay for it. As we covered, homeowners who buy a conventional mortgage - a term we'll explain in a bit - typically have PMI tacked onto their loan when their Loan To Value ratio is higher than 80%.
The cost of the PMI can vary by a number of factors, such as your credit score or the stability of your income. While the range of insurance rates is different depending on who you ask, it is not uncommon to see PMI rates between 0.5%-1.5% of the value of the loan each year. For example, if you have a home loan of $150,000 and your PMI rate is 1%, this means that your insurance would cost $1,500 ($125/month), which could be added onto your payment or paid as a lump sum depending on the lender's regulations.
Do All Lenders Require PMI For High Risk Borrowers?
No, and as a matter of a fact it's important that we clarify the type of mortgage to which PMI can be attached. While there are many types, I most frequently see traditional, nontraditional, VA, and FHA mortgages.
- Conventional or traditional mortgages are those that adhere to the 80% LTV requirements, and tack on PMI to borrowers under the threshold.
- Nontraditional or alternative mortgages are those that do not necessarily require PMI for those who don't pay large down payments, and offer unique structures such as interest-only payments and adjustable rates. Alternative mortgages are becoming more and more popular for borrowers who don't fit conventional guidelines or simply looking for a variety of options. While avoiding PMI using these loans may sound great, they often come with other risks that should be fully understood before applying.
- Military service members and veterans could qualify for a VA loan, which offers up to 100% financing with no PMI.
- FHA mortgages stand alone when it comes to their relationship with PMI. While conventional mortgages require PMI for borrowers who don't meet their guidelines, FHA loans can require a different form of insurance called Mortgage Insurance Premium (MIP). Unlike PMI, whose rates can vary based on not only the lender but also the financial strength of the applicant, the formula for calculating MIP rates is more definitive. Determining if you're eligible to have your MIP removed, however, is not as cut and dry as with Primary Mortgage Insurance. Some borrowers with FHA loans carrying Mortgage Insurance Premium will be given options for its removal, while others could have to pay these premiums for the entirety of the loan period. The determining factors are how much of a down payment was placed with the loan application, and also the date of mortgage origination. If you have or are interested in an FHA loan, you can find more information about Mortgage Insurance Premiums on their website.
How Does PMI Affect Your Taxes?
For younger workers or those making a lower income, having PMI on a mortgage is often a consideration because they may not be able to put down 20% of their home's value as a down payment. It's not ideal to have any amount added onto your payment if it can be avoided, however PMI does affect your taxes differently based on your level of income. In 2017, certain homeowners with qualifying loans could claim their PMI payments on their taxes as a deduction, while owners' ability to deduct payments if they earned at or above the threshold was phased out. At the time of this writing, our country is still in the midst of negotiations for potential changes in the tax code, so for now we won't cover what those limits are, and instead we'll encourage you to seek the counsel of your tax professional if you have PMI on your loan and are wondering how it will affect your taxes moving forward.
How Do You Avoid PMI Or Have It Removed?
There are multiple ways to get PMI removed from your mortgage. Here are a few options:
- Reach 78% LTV: once a borrower reaches 78% LTV, meaning they've paid off 22% of the home's appraised value at the time of the application, lenders must automatically remove PMI from their loan.
- Request removal in writing: while it's great that PMI automatically comes off your loan once you've reached 78% LTV, you only have to reach 80% to be eligible. Rather than waiting to pay down another 2% of the loan balance, lenders will remove PMI for qualified borrowers if they request it in writing.
- Search for a Nontraditional or VA loan: while we've issued a word of caution on nontraditional loans, there are some that are more stable than others. The doctor loan, which we've covered on this blog, allows physicians and dentists to put down 0%-5% without PMI. There are also what's called nonconforming loans, which allow borrowers to put down as little as 3%-10% and avoid PMI, while maintaining a similar structure (fixed rate and loan period, repayment of principal and interest) to conventional loans.
- Ask for an appraisal reconsideration: we've been talking about reaching 80% LTV by paying off 20% of the home's value at the time of application. But what if your home has significantly increased its value since that time? You can ask your lender for a reconsideration, which would require a new appraisal of your home's value, among other things. Proving this without actually changing the structure of your loan can be difficult. Many people choose to simply refinance their loan instead.
- Refinance: if your home has appreciated in value since the time of purchase, refinancing to a new loan may allow you to go into the application process with enough equity to avoid PMI. With mortgage rates being lower than they've been in recent history, doing so might also give you the opportunity to improve your loan terms if you're refinancing an older loan. If by refinancing you somehow put yourself in a worse situation regarding the structure of your loan, the appraisal reconsideration would be the more attractive of these two particular choices.