After years of carefully saving your money and securing your career for long term financial stability, you are finally ready to take the plunge into home ownership. You have been working closely with a committed real estate agent and finally located the home of your dreams. In the meantime, real estate prices have steadily risen and you no longer have the 20 percent down payment required by most lenders. What can you do about this situation?
One answer is private mortgage insurance, or PMI. Private mortgage insurance is a way for a home buyer to secure a mortgage with a down payment less than the usual 20% required by most non-governmental lenders. PMI mortgage insurance is not like government insured mortgages, or guaranteed mortgage loans that require down payments of only 0% to 10% depending upon the type of loan, such as FHA and VA loans.
Since private lenders, such as banks and savings and loans, want to lend money to credit worthy consumers a problem can arise when property values have risen faster than savings. From a mortgage loan point of view, lending money to home buyers having less than 20% of the purchase price available for making a down payment increases the risk of default on the home buyer's part. PMI mortgage insurance is one solution to this problem by insuring the lender's interests in granting the mortgage.
The cost of private mortgage insurance is paid by the borrower. Typically, a small percentage, say one-half to one percent is added to the loan's interest rate to cover the cost. Naturally, this increases the borrower's monthly mortgage loan payment slightly.
PMI does not cover the full amount of the mortgage, only the difference between the appraised value and the percentage of that value the down payment represents. In other words, if a borrower is able to make a down payment of 10% of selling price, the lender will require the borrower to purchase PMI of the other 10% to make up the difference.
The reason for insuring the lender's risk by requiring PMI mortgage insurance is that borrowers unable to make a 20 % down payment are more likely to default on their mortgage loan. If the borrower default on his payments and the home is subsequently foreclosed, the lender will attempt to recover some portion of the loss by selling the home, usually at a loss, at auction. PMI pays the lender, not the borrower when foreclosure happens.
From a home buyer's perspective the larger the down payment is the lower the mortgage interest rate is likely to be. Comparing loan-to-value interest rate tables from different lenders can be quite an eye-opener. A difference of one-quarter to one-half percent interest on a sizable mortgage loan can make significant difference in the monthly mortgage payment amount once the cost of mortgage insurance is added in.
The amount of money borrowed from the lender compared to the appraised value of the property is the loan-to-value ratio. Property values will change over time as market conditions dictate. In some areas, especially high population growth metropolitan areas, property values are falling, while is others they have remained relatively unchanged. Home buyers should pay attention to the value of their home as the principle is slowly paid down and property values follow area trends. In a situation where the loan-to-value, or LTV, amount of a mortgage falls to less than 80%, PMI is no longer required. In this situation, the borrower should contact the lender and request termination of the PMI.
Homebuyers with outstanding credit rating and low debt-to-income ratios should work closely with their mortgage lender in determining the need for PMI. In some cases, lenders are willing to accept full payment of PMI upfront when granting the mortgage.
If Private Mortgage Insurance is cancelled, the amount of monthly mortgage payments is reduced accordingly. Note that lenders may require that borrowers pay for an updated property appraisal in order to justify the cancellation of PMI. Homeowners with PMI attached to their mortgage loan would do well to pay attention to the value of their home relative to real estate market trends in their respective area.