The prospect of buying a new home, especially for a first time buyer, can oft times seem daunting. This is reality for any number of reasons, not the least of which includes the buyer undertaking a potentially significant financial commitment. For the un-indoctrinated, this new responsibility may seem even more overwhelming when it comes time to actually close. As any realtor or real estate attorney can tell you, it’s one thing for buyers to “logically" understand what it means to take on this monthly, long-term obligation, and quite another when it comes time to take pen to paper after seeing numbers reduced to writing. Add everything up – principal, interest, hazard insurance, taxes, possibly HOA fees – and that monthly fee might seem like more than you initially bargained for. Can it get worse? Possibly, depending on your circumstances.
When it comes to taking out a mortgage, many buyers often find themselves faced with an additional yet surprisingly unexpected fee that gets rolled in to their monthly payment. I say surprising because it’s always my hope that buyers come to me already educated about the process and their anticipated payments. That doesn’t always happen, so it falls on me to take on the role of educator (a role I’m generally happy to assume). So, without further ado, what is this additional fee? Depending on how large (or small) a down payment you make toward the purchase of your home, you could be on the hook for paying an additional monthly premium known as PMI or private mortgage insurance.
When first confronted with the notion of paying a monthly PMI amount, people inevitably ask, “why the heck do I have to pay that too?!" Once you understand the underlying rationale, it’s actually somewhat intuitive, even if no less easy to swallow.
Allow me to take a step back and explain how PMI works. Private mortgage insurance is primarily used when a buyer is borrowing more than 80 percent of a home’s purchase price (or, if any simpler, putting down less than a 20 percent down payment on a home). PMI charges can vary, but they usually amount to one-half of 1 percent of a loan’s value.
There’s a bright side though! I’m happy to tell you that PMI payments are only temporary – well, depending on your perspective at least. One needs to pay PMI only for as long as his or her loan-to-value ratio exceeds 80 percent. As soon as you have 20 percent equity in your home, you no longer need to make PMI payments. That said and all things considered equal, those who make smaller down payments at the beginning will obviously end up paying PMI for a longer period of time than someone who was already close to that 20 percent mark (hence the reason “temporary" is entirely dependent on your own circumstances).
Although PMI is not required by law, The Homeowners Protection Act of 1998, which took effect in 1999, requires lenders to tell buyers how long it will take for them to reach that 80 percent level; you’ll usually receive a handy dandy schedule outlining the life of the payments at the time you close. It also requires lenders to automatically cancel PMI when your loan-to-value ratio hits 78 percent. Wait a minute – didn’t you just say the benchmark was 80 percent? Yep, I did, and that IS the correct benchmark. Here’s the rub – lenders nonetheless have the right to continue charging PMI until you reach that 22 percent equity level UNLESS you take action. While lenders can wait until you reach that 78 percent level to automatically discontinue payments, they are likewise obligated to discontinue if, once you reach 80 percent, you direct them to discontinue PMI. This will require you to pay a bit of attention as far as tracking your payments is concerned. At the end of the day, however, that little bit of effort can mean a fair savings over time.
Now that we’ve gone through the general inner workings of PMI, you might still be wondering why PMI necessary in the first place and what’s in it for you? We’ve sort of alluded to it already. At its most fundamental level, private mortgage insurance permits lenders to protect themselves against a heightened risk of loan default while allowing buyers to purchase with a smaller down payment. In the financial world, when one borrows more than 80 percent of a home’s purchase price (or the house’s fair market value), mortgage lenders generally consider that to be a bad risk since the risk of foreclosure on those purchases is historically significantly higher.
Does it sound like the lender is reaping all of the rewards of PMI? While it might, that’s not really the case. The critical item of import to remember about PMI is that it allows individuals with just 5 or 10 percent down to purchase homes. Given that those who make smaller down payments are in a higher risk category for default, these loans weren’t always possible. Now they are. PMI provides lenders with a level of protection that enables them to offer more loans to those who often find themselves with less liquid cash available to make down payments.
While the thought of an additional line item rolled into your monthly mortgage payment may be less than pleasant, I’d offer you this bit of solace: but for the inconvenience of paying PMI, many lenders might not have seen fit to make your loan. Take it for what it is, and just be sure to cancel your PMI as soon as possible so you don’t pay more than necessary!