When my wife and I bought our first home, the most we could put down on the home was five percent. As a result, we had to pay private mortgage insurance (PMI) to qualify for the loan. Each month our mortgage payment included the premium for PMI, and I absolutely hated paying it.
If your not familiar with PMI, it is insurance that some homeowners must purchase to qualify for the loan. PMI protects the lender in the event that the homeowner fails to pay their mortgage. In other words, you are paying for insurance that protects the lender, not you.
The good news is that there are ways to avoid paying PMI.
20% Down Payment
When you apply for a mortgage, the lender considers several factors to ascertain your credit worthiness. These include things like your credit score, income, and other debt. Lenders also look at the amount of the loan you are requesting compared to the value of the home. Called a loan to value ratio (LTV), the LTV can affect the interest you’ll pay as well as PMI.
If your home is valued at $200,000 and you want to borrow $150,000, your LTV is 75% (150,000 / 200,000). If your LTV is above 80%, lenders will typically require you to pay PMI. So the first way to avoid PMI is make a down payment equal to or greater than 20% of the purchase price of the home.
If you are just starting out, however, a 20% down payment may be more than you can handle. Fortunately, there are other ways to avoid PMI.
Get a Second Loan
My wife and I took this approach with our second home. The most we could afford was a 15% down payment. But rather than getting a loan equal to 85% of the purchase price and paying PMI, we got two loans. The first mortgage was for 80% of the purchase price, so we didn’t have to pay PMI. And we got a home equity line of credit for the remaining 5%.
With a home equity line of credit, you don’t have to pay PMI. The downside is that the interest rate is higher than on a first mortgage. When we bought our second home in 2004, however, PMI was not tax deductible. The interest we paid on the second mortgage was. And we could pay it off relatively quickly.
While this approach is still worth considering, it’s important to note that PMI today is tax deductible. Whether it will remain tax deductible is an open question. But given the very low mortgage rates today, a second loan may still beat the cost of PMI.
Watch the Value of Your Home
If you can’t or didn’t avoid PMI with the above two options, you have a third option. Once the balance of your loan dips below 80% of the home’s value, the lender must remove the PMI requirement. With our first home, increased home values eventually took us below the 80% threshold, and we got out from under the PMI. Today, however, there is a twist to this approach.
Even if you don’t request it, your mortgage lender is required by law to cancel your PMI once your loan is down to an LTV of 78%, provided that you are current on your loan. If your mortgage is considered “high-risk”, your PMI will not be automatically cancelled until you pay down your mortgage to an LTV of 77%.
This requirement (new as of 1999) seems like a huge benefit to homeowners. It’s not. Remember that there are two ways to get your loan below an LTV of 80%: (1) paying down the principal, or (2) increasing the value of your home. Because the payments you make in the early years of a mortgage go mostly to interest, it can take years on a 30-year mortgage before you reach the 78% threshold. But if home values go up, you can get rid of PMI much faster.
And here’s the catch. A lender is not going to reasses the value of your home on its own to see if you can get rid of PMI. They will eliminate the PMI only when your payments bring your loan down to 78% of the purchase price, which can take forever. But when home values go up, and they will go up, you can take the initiative to have your home appraised. That’s what my wife and I did on our first home, and we were able to stop paying PMI after just a few years.