If you are considering shopping for a home you have probably heard of private mortgage insurance (PMI). Hearing about PMI and understanding mortgage insurance are two very different things. So what is it? Who benefits from it? Do you have to have it?
Let’s set the stage.
You’ve decided it’s time to move out of your apartment. No longer will you share a washer and dryer with a building full of strangers ready to toss your clothes on the floor moments after the machine buzzes.
You’ve done the math. A reasonable place in a desirable neighborhood will cost you what you pay now in rent! Who wouldn’t want to pay off their own debt instead of the debt of their landlord?
It might need a little fixing up, but you’ve watched enough HGTV. Knock out a wall or two, create a more open concept, add some shiplap. You’ve got this!
You type your purchase price into an online mortgage payment calculator. A $200k house, check. You’ve saved up 10k to put on the loan, check. You have pretty good credit, check. You press “calculate.”
Principle and Interest seem affordable, at about $900/month. Homeowners Insurance? You’ll have to call about that. But then, your payment has this additional monthly charge and it’s $120/month? What is it and why is it so much? That pesky monthly payment is mortgage insurance.
In most cases, if you, the borrower, are not able to come up with 20% of the purchase price of the home you will have to pay some kind of mortgage insurance. You can’t wish it away. Your stellar credit score can’t rid you of this obligation. The only way to avoid paying this monthly fee is to come up with a 20% down payment. So what is mortgage insurance?
As its name implies, mortgage insurance (often referred to as PMI or MIP), is an insurance policy. You, the borrower, pay a monthly premium to protect the lender in the event that you default on the loan. You reap not one monetary benefit from the monthly payment of this premium. To know the impact of mortgage insurance on your wallet you’ll need to first know what type of loan you intend to use and then if you’ll qualify. The two more common types of home loans are Conventional Loans and FHA loans.
A conventional loan is the most common home loan. Qualifying for a conventional mortgage (among a few other criteria) usually requires a credit score of around 630 or higher and a debt-to-income ratio of 43% or less. With a conventional loan, a borrower is required to pay Private Mortgage Insurance (PMI) until their Loan-to-Value Ratio (LTV) reaches 80% or less. In this example, on a 30 year standard repayment it will take over 9 years to remove PMI and cost somewhere north of $11k. You might as well light a one hundred dollar bill on fire every month for the next 9 years. It’s also worth noting that PMI can be more than the $120 example. The premium is impacted by your LTV ratio, credit score, and debt-to-income ratio.
An FHA loan is a loan secured by the Federal Housing Administration. A borrower with less than perfect credit and a smaller down payment might look to an FHA loan. If you utilize an FHA loan your mortgage insurance premium (abbreviated MIP) looks a bit different. With a down payment of less than 10%, MIP is paid every month until the home is paid off or unless you refinance. A down payment greater than 10%, but less than 20% still lands you with an obligation to pay MIP, but for 11 years, not for the life of the loan. Regardless of the amount of the down payment, your MIP decreases as the LTV ratio decreases. In either scenario you will also be required to pay an upfront premium as well, likely somewhere just south of 1% of the loan.
So what are you supposed to do if you can’t come up with 20%?
I’m not suggesting you rent forever. I think it’s important to love where you live (as long as it’s a reasonable financial decision). But, it’s equally important to understand your cash flow and the impact of your monthly expenses. Ideally, I want to see you have at least 10% of the purchase price saved. Saving this cash serves two purposes. It teaches you to live without it and gets you closer to living a life without PMI.
Bottom line. Avoid it if you can. If you can’t? Qualify for a conventional mortgage and pay down your loan as fast as possible. You’ll build equity in your current home and rid yourself of PMI sooner without the extra payments.