Traditionally, a down payment of 20% was required for conventional home loans, which was often a monstrous obstacle to buying a home. Trying to save a $50,000 down payment for a $250,000 home is no small feat!
Today, it’s not uncommon to find conventional loans with 3% or 5% down payment requirements thanks to something called PMI, or private mortgage insurance. PMI is insurance that’s paid for by the homeowner and increases their monthly mortgage payment. Its purpose is to protect the lender if the borrower becomes unable to pay, as the lender is at greater risk when making home loans with low down payments.
PMI has its pros and cons. We’ll dive into these in this article, but a high-level list includes:
- Helps people become homeowners earlier – before they have a 20% down payment
- Typically required only for the early part of the loan
- Easy to pay as part of a monthly home loan payment
- Higher credit scores and/or down payments can mean lower PMI costs
- Increases your monthly home loan payment for the early part of your loan
- The cost of PMI varies – another variable to factor in when choosing your lender
- Lower credit scores and/or down payments can mean higher PMI costs
How PMI Works
For conventional loans, PMI is commonly paid as part of your monthly home loan payment. As a form of insurance, the PMI cost is referred to as a “premium,” and is calculated on a percentage basis. Your lender will disclose the PMI portion of your loan payment before you sign to close your home loan. PMI typically isn’t paid for the life of your loan – just the early stages – something we’ll explore further in the “Removing PMI” section below.
How Much Does PMI Cost?
The average annual cost of PMI ranges from 0.55% to 2.25% of the original loan amount, according to a recent study by the Urban Institute. Where in that range will you land? That depends on your specific loan terms, your credit score, and your lender. A higher down payment and/or higher credit score should net you a lower PMI cost. And yes, your PMI rate can vary depending on the lender you choose, so choose a lender who has your best interests at heart! (Solarity, for instance, has negotiated reduced PMI premiums for our members.)
So what will “0.55% to 2.25%” mean to your monthly payment? Let’s say you’re making a 5% down payment on a home costing $289,900 (the median listing price of U.S. homes as of July 31, 2019 according to Zillow). If you’re paying 1% for PMI, that equates to about $230 per month, or $2,760 added to your home loan payments over the course of a year.
Mortgage insurance for federally guaranteed loans, such as FHA or USDA loans, operates a little differently from PMI for conventional mortgages. VA loans don’t require mortgage insurance but may include a “funding fee.”
PMI vs. Saving for a 20% Down Payment
Depending on your situation and financial assumptions, buying earlier with PMI may well put you ahead of where you’d be if you continued to rent while saving for that 20% down payment to avoid PMI. As with any financial analysis, your specific situation and your assumptions are key. Here are some figures to consider:
- Home values have increased 3.6% per year since 1991 (as of 5/2019, according to a recent Federal Housing Finance Agency report).
- It may take five years to save an additional 15% down payment required to avoid PMI (as an example, 15% of the median home price listed above would be just over $43,000).
- How much will you pay in rent over those five years?
- As you’re saving, the home you want to buy is most likely appreciating. At a 3.6% annual growth rate, that $43,000 figure (for example) becomes nearly $52,000 in five years.
- Other factors to consider: Your first five years of mortgage payments will reduce the principal of your loan (by at least a little)... Earnings on your savings may help grow your down payment... there are lots of factors you could include in your analysis.
Don’t let these figures daunt you! For some people, their analysis places them significantly ahead of the game after five years of PMI payments. In short, every person’s situation is different. It’s good to keep in mind the potential benefits of buying earlier, and then weigh those benefits against the concrete cost of PMI payments.
At a minimum, the federal Homeowners Protection Act ensures two primary ways to remove PMI from your loan:
- You can contact your loan servicer in writing about removing PMI from your mortgage when your loan balance falls to 80 percent of the original value of your home.
- Even if you don’t ask for PMI to be canceled, your loan servicer must terminate PMI when your loan balance is scheduled to reach 78 percent of the home’s original value.
There are details and conditions (you’ll need to be current on your payments, for instance), and you can find a great summary of these provisions on the site of the Consumer Financial Protection Bureau.
Your lender may have more generous PMI cancellation options available to you, or they may not. Many homeowners opt to take their PMI destiny into their own hands, and refinance their loans as a way to remove PMI requirements earlier, particularly when:
- They believe their home has appreciated beyond its original valuation, and/or
- They have additional money to put down.
If one or both of these factors brings your home loan amount below 80% of the (new) value of your home, PMI won’t be required on your new loan. It’s important to keep interest rates in mind when considering refinancing and to factor in the cost of the refinance (they’re generally not free), but if the math works out and your home appraises for what you think it should, this could be a great option for removing PMI.
Bringing it All Together
Private mortgage insurance adds to your monthly mortgage expenses, but it can help you get your foot in the homeownership door. There are a lot of considerations to take into account, but a great lender will be happy to walk you through your options and figure out what’s best for you. In fact, that’s what Solarity does best!