Private Mortgage Insurance, or PMI, is a type of insurance that helps protect the lender against losses should the buyer default on his or her loan. It is generally required by the lender when the buyer has a down payment less than 20% of the selling price of the property. PMI allows the lender to safely accept lower down payments than would normally be permitted.
PMI is not additional homeowners’ insurance. It is for the sole protection and benefit of the lender. If the house were to go into foreclosure, only the lender’s interest in the property would be addressed. The only benefit of PMI to the buyer is that it may allow him or her to acquire the property with less up-front money, thus avoiding the need of a 20% down payment.
Lenders require private mortgage insurance to be in place on a mortgage for as long as the principal balance is above 80% of the value of the home. Once the buyer pays the mortgage down to that level, the PMI can usually be cancelled. However, it can take quite a number of years for the principal balance of a mortgage loan to fall to 80% LTV (Loan-to-Value).
Clearly, PMI has some advantages. As stated above, it affords the lender more security to grant a mortgage loan to the buyer who doesn’t have a big down payment. Both parties benefit. But there are drawbacks as well. One major disadvantage is that the PMI premium raises the buyers’ monthly payment, and unlike mortgage interest, it is not tax deductible.
So, do you really need PMI? Well, unless you are working with a lender in a loan program with government backing (FHA or VA loans, for example), the answer is yes. The lender will require it if you don’t have 20% or more to put down. Are there ways to get around it? The answer again, is yes.
There are several ways to avoid the PMI premium. One common method is with combination financing, also known as a piggyback loan. With this type of financing, the buyer takes out a first mortgage for 80% of the purchase price of the home as well as a second mortgage for the remainder of the purchase price (less whatever down-payment money is applied). Since the first mortgage is for only 80%, PMI is not needed. And both loans are tax-deductible. (Be sure to always consult with your attorney or accountant for specific details.) Use our Second Loan or PMI? Calculator to help you determine which might be best for you. Another way to avoid the monthly PMI obligation would be to add the entire premium to the mortgage at closing and finance the entire amount, including it in your normal monthly payment.
There are other options available that can help you get around the PMI premium. Do your homework. Study Understanding the Cost of Private Mortgage Insurance. Talk to several mortgage lenders. They will be able to help educate you on which solution may work best for your situation. Remember, knowledge is the key to making sound financial decisions.