Takeaways
- Lenders require borrowers of conventional loans to pay PMI if their down payment is less than 20% of the home’s purchase price.
- PMI is usually part of your monthly housing payment.
- You can eliminate PMI by paying over 20% of your mortgage’s principal.
- PMI should be accounted for when considering how much home you can afford.
- Saving a large enough down payment upfront is a smart money move.
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Buying your first home is one of the most memorable transactions of your lifetime. But it comes with one major hurdle: saving a large enough down payment. A down payment is the amount of cash you will need to pay upfront when purchasing your house, expressed as a percentage of your home’s total purchase price.
How much you put down for a conventional loan will dictate whether you will be required to buy private mortgage insurance (PMI). The general rule of thumb is that lenders of conventional loans will require a down payment of at least 20% of the home value.
The good news is that if you have found the perfect house and don’t quite have the 20% down payment to avoid PMI, it doesn’t mean you can’t buy the house. Instead, lenders offer you the ability to purchase the house but require you to purchase PMI as part of the transaction as additional insurance protecting the lender. Private mortgage insurancegives the lender comfort with the loan risk and allows you to start life in your new home.
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What is Private Mortgage Insurance?
Private mortgage insurance is insurance required by the lender of a conventional loan where you do not put down at least 20% of the home value. PMI is designed to protect the underwriting lender from you defaulting on high loan-to-value mortgages.
Loan-to-value is one of the ratios used by lenders to determine the risk of a new loan. Loan-to-value is the ratio of the total amount of the loan divided by the assessed value of your home. If this ratio exceeds 80%, lenders consider this a higher-risk loan because they believe borrowers are more likely to default on high loan-to-value compared to lower loan-to-value loans.
Smart Tip:
Lenders also review your credit score and examine financial ratios like your debt-to-income ratio. Reducing debt and cleaning up your credit before starting the home-buying process could save you thousands of dollars in interest payments in the long run.
How to Avoid PMI
With proper financial planning and a little know-how, private mortgage insurance can be avoided altogether. Here are several ways to avoid paying PMI.
- Make a 20% Down Payment: For most homebuyers, the down payment is the barrier to entry into the housing market. The fastest and cleanest way to avoid private mortgage insurance is to save at least 20% of your home’s value in cash and make a substantial down payment.
It might be tempting when perusing websites like Zillow to realize you can afford the monthly mortgage payments of a house you love. The question is whether you can afford to pay the down payment. After analyzing how much house you can afford, you need to set up a savings account and save for your down payment.
Depending on your financial situation and the size of the house you want, saving for a down payment could take a couple of months or years. But if you simply must have your house, there are ways to purchase your home with PMI and eventually eliminate your private mortgage insurance payment.
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- Accrue 20% Equity: For those who want to leap into homeownership without making a 20% down payment, there are ways to get rid of PMI early. After you purchase your house, you can prepay your mortgage principal to accrue at least 20% equity in your home. This means your loan-to-value ratio is now 80% to 20%, and you can request to cancel your PMI with your lender.
Prepaying your mortgage principal can be a smart money move in many scenarios. Prepaying mortgage principal to get rid of the extra cost of PMI is one of those decisions. Accruing equity (ownership) in your home allows you to borrow against your home in the future.
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- Get a Piggyback Mortgage: Another route to avoid PMI is to qualify for a Piggyback mortgage. By using a Piggyback mortgage, you effectively get two mortgages for one home. An example of a typical piggyback mortgage structure is 80-10-10. In this example, your first mortgage covers 80% of the purchase price, a second mortgage covers another 10% of the purchase price, and the final 10% is a down payment. In this scenario, you can avoid PMI because the loan-to-value ratio of the first loan is not above 80% of the purchase price. Securing a second mortgage can get a little complicated, so make sure you do your research.
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When Can You Stop Paying PMI?
Eventually, you will be able to stop paying private mortgage insurance. The federal Homeowners Protection Act, also known as the PMI Cancellation Act, requires lenders to automatically cancel PMI once your mortgage’s loan-to-value ratio (LTV) dips to 78%.[1]
You can accelerate this process by making extra mortgage principal payments and staying current with your mortgage payments. Financial diligence eventually pays off.
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Does Every Mortgage Require PMI?
Not all mortgages require PMI, but it is usually required for conventional mortgages with a down payment of less than 20%. There are special government-backed loans like FHA loans and VA loans that have different insurance requirements. Insurance for these loans operates differently from traditional PMI.
Is PMI Tax Deductible?
For the tax year 2022, private mortgage insurance is not tax deductible. In 2019, Congress reintroduced the federal tax credit deduction for PMI if homeowners were itemizing their deductions. However, the deduction expired for the tax year 2022, and guidelines for the tax year 2023 have not been established.
How Much is PMI?
Private mortgage insurance rates vary based on various personal financial factors, including your credit score, length of loan (15-year mortgage vs. 30-year mortgage), and down payment. If you have a good credit score, your PMI will be lower than if you have a bad credit score. Additionally, there is an inverse relationship between your down payment and the cost of your private mortgage insurance. A high down payment reduces the cost of PMI. Check with your lender to see how much your PMI would be based on your finances.
Smart Summary
Buying your first home can be fun and exhilarating. However, it is essential to be financially prepared for one of the biggest transactions of your life. Make sure you prepare well in advance by having a healthy credit score, saving for your down payment in a high-yield savings account, and understanding the hidden costs of homeownership. Lastly, you will want to pick the best type of mortgage for your financial situation.
(1) Consumer Financial Protection Bureau. Homeowners Protection Act (HPA or PMI cancellation act) examination procedures. Last Accessed 7/20/2024
