Mortgage lenders will often require their borrowers to have various insurance policies in order for the loan offer to proceed. The policies they ask for borrowers to carry will depend on the circumstances of the loan and the home being purchased. These policies can either insure the structure of the home or, in the case of private mortgage insurance (PMI), to protect the lender.
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How Private Mortgage Insurance Works
Private mortgage insurance policies are used to protect mortgage lenders from any financial losses they might incur if a homeowner defaults on a loan and the property has to be foreclosed. Depending on how your loan is paid, your lender may require you to purchase a PMI policy.
Lenders will ask for PMI coverage from homeowners when their down payment is less than 20% of the value of the loan. When lenders evaluate the risk of offering a loan to potential home-buyers, they calculate a figure on the loan called the mortgage loan-to-value ratio which compares the value of the property that has been paid off by the borrower to the amount still owed.
How Lenders Decide PMI is Needed
Lenders prefer your LTV ratio to be lower than 80%, as that indicates less risk of financial loss to them on your loan since you already have 20% equity in your home and are statistically less likely to default on payments on your loan.
PMI policies are an additional cost for the homeowner, but these policies allow potential home buyers without the cash to pay larger down payments the opportunity to find desirable loans with affordable rates.
What You Can Do To Avoid Paying PMI
If you would like to obtain a loan without having to purchase a PMI policy, you generally have two options that would remove that cost: to save enough that you can pay a down payment of at least 20% of the home’s purchase price or purchase a piggyback mortgage.
If you qualify for this option, obtaining a piggyback loan can help you reduce the risk of financial loss to your potential lenders, which will give them less of a reason to require that you pay for insurance that protects their profits from their loan to you. The way a piggyback mortgage works is that it splits the value of the loan between two mortgages.
When your lender offers you the piggyback mortgage, the two loan amounts plus your down payment would cover the total purchase price of the home. If your loan is split 60% for the first mortgage, 25% for the second, and 15% from the down payment, your LTV will be considered per mortgage and will be low enough that PMI coverage isn’t needed.
Another option would be to pursue a lender-paid mortgage, where PMI coverage is paid directly by your lender and the costs are incorporated into your monthly mortgage payment as part of the mortgage interest rate.
Finally, if you’re unable to avoid purchasing a PMI policy, you still may have the option of removing this additional cost. If you decide to refinance your loan, you would have the opportunity to obtain a loan with terms that don’t include the need for PMI policy coverage.
In that situation, you would have to weigh the costs you would incur from refinancing in comparison with what you would spend if you kept paying your PMI premiums.
Alternatively, you could prepay the mortgage principal in order to increase your equity or ownership in the home to 20% or more. This would reduce your LTV ratio, which would make it more likely for your lender to remove the PMI coverage requirement if you request it to be canceled at that time.
Regardless of which insurer you have, once your equity in the home equals 22% or more, legally, your lender is legally required to cancel PMI insurance, according to the federal Homeowners Protection Act, so unless you choose a lender-paid mortgage, your PMI payments will not have to last the length of your loan.