WHAT IS PMI? Private Mortgage Insurance Explained
When a lender looks at a loan application, their main question is "what risk do I take on by issuing this loan?" Because that is what a loan is, it is a risk and an investment that the person taking out the loan will be able to sufficiently pay the loan off for a period of 5, 10, 15, 20 or 30 years.
Credit checks, bank statements, employment verification – all the documentation required when getting approved for a loan may seem like you are giving the lender every tidbit of information about yourself and it is true. I even joke that it feels like the list or requests may even contain a request for a colonoscopy.
But let’s look at it from the perspective of the lender. They are backing your purchase of a home and have to evaluate you and the property to determine what the odds are that the loan will go into default. At the closing table, the seller gets the full amount which is paid by the lender and all the lender gets is a promise of payment and well, collateral- your home.
This is why a down payment is such a crucial part of obtaining a home loan. When a borrower has a substantial down payment (20 to 30% or more), the lender's exposure is lessened in the event the borrower doesn’t pay or as we refer to it, default. They know they can sell the property through foreclosure and get their money back and recoup any costs because again, they have that 20-30% downpayment.
This 20-30% figure used to be required, yet clearly this acted as a barrier to entry for homeownership, especially first time buyers. That is until 1957, when Max H. Karl, a real estate attorney, founded Mortgage Guaranty Insurance Corporation and invented the modern form of Private Mortgage Insurance (PMI.)
The concept of PMI is pretty cool. You are taking out insurance on the property. This insurance is a guarantee to the note bearer (or your lender) that you will continue to make your mortgage payments until you get to the 20% mark. This insurance pays out the mortgage company in case anything happens.
It is a win-win situation. You get the home you wanted and the mortgage company gets extra assurance of their investment in your ability to pay.
Instead of coming to the table with 20% or more for a down payment, a private mortgage insurance policy allows consumers to buy and finance a home without a large down payment. With PMI, the borrower pays a small percentage of the total loan amount (this is typically around 0.3 - 1.5%/year) in addition to their mortgage and insurance payments. As an example, a $200,000 loan with a PMI rate of 1% will come out to $167 dollars extra a month for a borrower. It's not nothing, but for many it's a manageable trade off.
This is where you compare what rent is versus your mortgage payment and add in that extra PMI payment and more often than not- it is STILL cheaper to buy than rent. So don’t be thrown by that extra number, you always have to keep everything in perspective and think of the big picture.
Sometimes PMI can get a bad rap, as something to be avoided at all costs. Until the end of the 90's this attitude was understandable – homeowners had limited resources to cancel PMI and were often stuck with it for the life of their loan. That changed with the Homeowners Protection Act of 1998. It required automatic termination of PMI when the loan balance reaches 78% of the original value through natural amortization. Borrowers can often drop their PMI even before reaching that 78% figure – once a borrower reaches 20% equity in their home, they can request a cancellation of PMI. Most forget and that is what the PMI insurance company is hoping on, I mean they get extra payments so why wouldn’t they.
As home prices continue to rise, borrowers build up equity in their homes faster, meaning they can often drop PMI payments earlier than they think.
If you're curious about buying a home for the first time, or you're wondering how the value of your home has changed over time, reach out to me. I have up-to-date market information to help you make decisions with confidence.
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