Buying a home is a major financial decision and one of the most important ones most people will make. Finding a home to purchase is really only the beginning. Unless the buyer has a lot of cash on hand or a lot of liquid assets, they will have to take out a loan and find a mortgage to buy the house and there are many fees and expenses when it comes to buying a home. However, one such expense that not many potential home buyers are completely educated about is something called PMI. PMI stands for private mortgage insurance. Keep this added cost in mind when negotiating a deal on your next home purchase.
What Exactly is PMI?
Private mortgage insurance is something that lenders will require most people who take out a mortgage on a home to pay extra for. The private mortgage insurance is there to help protect the lenders who own the mortgage. The PMI is there to minimize the risk of the home losing value or the borrower defaulting. Sometimes home prices may fall, and this could be a problem for the lender because if the home owner doesn’t have enough equity in the house and defaults on the loan, the lender could lose a lot of money. If the home isn’t worth what it was originally valued at and the payments go into default, the private mortgage insurance will allow the lender to pay off the house without taking a substantial loss.
However, not just the lender benefits from PMI. Thanks to this insurance, it allows many homeowners to buy a home when they otherwise wouldn’t be able to. The general rule of thumb is that you need 20 percent down when buying a home and avoiding PMI. Well, given today’s home prices that could mean some people may never be able to buy a home.
How can PMI be eliminated?
One way to avoid PMI completely is to put down at least 20 percent or more of a down payment on the home. By putting down at least 20%, the mortgage lender should be well protected in terms of enough equity in the home. However, this option can be difficult to achieve for people who don’t have a lot of savings or assets which can be converted to cash easily.
If the home owner does not have a 20% down payment up front the PMI will have to be paid. The PMI is usually a separate payment, but gets lumped into your monthly mortgage payment. This is what makes it tricky for homeowners because they rarely pay attention to how much it’s actually costing them. In some cases it can be a few hundred dollars a month.
Legislation was passed that says that home owners must be notified of any PMI they will be paying. The law requires the procedure and qualifications for having it canceled are spelled out clearly. This will allow the cancellation of the PMI when there is enough equity in the home.
This process usually involves having to mail a letter to the mortgage lender. Most lenders will have an official form which would need to be completed. The home buyer must then also include proof that the home has a 20% equity level. This usually involves having a state-certified appraisal done.
Another method in which a PMI may be eliminated is through something commonly called a piggyback mortgage. It is also commonly referred to as an 80-10-10 mortgage. This is accomplished by a second mortgage being given either through refinancing the home at a later time or a second mortgage being taken out during the initial purchase.
There can be multiple forms of a piggyback mortgage; however what follows is the most typical type used. The 80 comes from 80% of a lien put on the home. One of the 10s stands for a 10% down payment. The other 10 represents 10% of a second mortgage.
The piggyback loan can be beneficial to home buyers in the form of equity. The payment is putting at least some equity back into the home. Whereas, when a home buyer has to have PMI, that portion of the mortgage payment isn’t going towards the principal and putting equity in the home and instead goes to an insurance company.
It used to be that the piggyback mortgage was the only option of the two which allowed for tax benefits. Second mortgage payments are tax deductible. However, congress passed laws which make the portion of the mortgage payments made to cover the PMI also tax deductible and will remain so through 2011.
It Will Cost You Either Way
Whether you opt to pay PMI because you can’t put 20 percent down or go for a piggyback mortgage, not having the down payment will cost you. It will either be in the form of an added insurance premium or a little added interest with the second mortgage. That being said, it’s obvious that the best idea is to come to the table with a large enough down payment, but that isn’t always a viable option.
So, just understand going in that you’ll be paying a little something extra. Also keep in mind that any down payment is better than no down payment. Even if it’s just 10 percent, as long as the market value of your home doesn’t drop significantly, that means you’ll reach your 20 percent equity sooner and be able to cancel PMI in a relatively short amount of time.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Many lenders will actually notify you when you have satisfied the 80% equity mark to drop PMI. But, you should also call them regularly when you think you're getting close. Generally they'll ask you to mail a letter formally requesting the cancellation. Sure, you could wait, but catching it yourself could save you more than a few hundred bucks!
We just happened to have our home reappraised when we applied for a Home Equity Line of Credit. The bank provided a free appraisal which we then used to show that our home has was worth more, thereby reducing the loan:value ratio. You have to know what to ask/request in order to have the PMI eliminated. By the way, I believe you can still claim the PMI on the Federal Tax return.