What Is Private Mortgage Insurance and Why Do I have to Pay It?
- Private mortgage insurance is basically protection for the lender against default. This insurance that you are paying for is the lenders safeguard in the event that you cannot make payments and the bank must foreclose. There are two types – insurance purchased from the government (FHA and VA) and those bought in the private market (hence, the “p” in PMI.) Whether or not you must pay for PMI is based on two main factors: your loan to value ratio and your debt to income ratio.
- Loan to value – this is simply the amount of money you borrowed divided by the value of the property. For example, if you purchased a home for $100,000 and you put down $10,000 you would be borrowing $90,000. $90,000 divided by $100,000 is 90%; therefore, you would have a loan to value ratio (LTV) of 90/10. Anything greater than 80/20 will require mortgage insurance. Once you reach 80% LTV, your lender has the option to drop the mortgage insurance, but most will not drop it automatically until the LTV reaches 78%. This is a lender choice. If there are other factors such as frequent home sales or a very low initial down payment as is often the case in a VA or FHA loan, the LTV may need to be much lower than that. On some loans, mortgage insurance will stick through the life of the loan. Be certain to ask your lender about this often unknown fact.
- Income to Debt Ratio – This is exactly what it sounds like. It is the money you bring in compared to what you owe. VA loans allow for the highest tolerance of debt while conventional allow for the least. Regardless of which loan type you choose, aiming for a debt to income ratio below 33/67 is always smart. The lower the better and the better risk you are to a lender. Also critical here is your credit score. The higher the better. Again, the less risk you pose as a borrower the less likely a lender is to feel the need for mortgage protection. This is all secondary of course to your LTV. A poor debt history can cause PMI to be required even if you have 20% down.
- How much is this going to cost me?
That depends. The premium has an inverse relationship with your down payment. As one goes up, the other goes down. Premiums have a large range – as low as $30 up to $100 a month for every $100,000 borrowed and are usually rolled into your monthly loan payment. That can add up. Think of it this way, on a $300,000 house, you could be paying as much as $300 a month in mortgage insurance which amounts to $3,600 a year. Even if you only pay that for the first 10 years of the loan, that is $36,000! OUCH! So you can see why it is beneficial to have as much saved for your down payment as possible.
- Can I avoid it?
Maybe. Talk to your lender about a piggyback loan. Basically you are taking out a second loan for the difference between your down payment and the 20% needed to avoid mortgage insurance.
When it comes to mortgage insurance, it is best to talk with a credible lender. Refer to my list on www.buyandsellwithlori.realtor. Wishing you smart and happy homeownership!
The lending world is a very complex one and your lender is by far the best source for information, which is why I always share the names and contact information for several lenders with whom I have worked in the past. It still doesn’t hurt to have some idea of what they are talking about when you enter their domain. I have broken down the basic loan types and structures as well as described a few options for special circumstances to help make the lending process a bit easier.
First of all, you need to be aware that there are numerous loan types and lenders are always coming up with creative solutions to help their clients. Here are the basics:
- Conforming vs. Nonconforming
The main difference between the two is that one follows the guidelines set forth by Fannie Mae and Freddie Mac (GSE eligibility) and the other does not. In most cases, the underwriting issue is with the loan amount. Anything over the amount set by Fannie Mae and Freddie Mac would be considered a jumbo loan and is subject in most cases to a higher interest rate because the risk is higher. That dollar number is subject to change yearly and is set higher in Alaska and in Hawaii.
- Conventional Loans vs. Government Loans
- Conventional: Simply put, a conventional loan is neither insured nor backed by the federal government. This is why qualifications for conventional loans are a bit stricter and the amount needed for a down payment is often higher. Recently, that number has been lowered, but you will still need to put down 20% to avoid paying private mortgage insurance.
- Government Loans
- FHA – stands for Federal Housing Administration and that is the entity that backs these loan types. It is managed by HUD (Housing and Urban Development.) Many people think these loans are limited to first time home buyers when in fact, they are open to a number of different borrowers. This program allows you to borrow money with as little as 3% down; however, you will have to pay for mortgage insurance for the life of the loan which will increase your monthly payments.
- VA – Veteran’s Affairs backs these loans and is a program available to military members and their families. These programs are also insured and backed by the federal government. The biggest advantage of these loans is that the borrower needs no down payment — 100% of these loans can be financed.
- USDA/RHS – United States Department of Agriculture offers loans to those borrowing for purchase in rural communities who meet certain income requirements. Generally, it cannot be higher than 115% of the adjusted area median income. These median incomes vary by county and the label of “rural” is also frequently changing, especially in high growth areas.
- Fixed Loans–many different structures can be created at your lender’s discretion, but these are the basics.
- 30 Year Fixed – your basic loan. This is just as it seems. It is an amortized loan that has a fixed rate and is designed to be paid off in its entirety in thirty years. Your monthly principal and interest payment would remain unchanged; however, if you escrow taxes and insurance and those fees increase (likely) your monthly note will also increase.
- 15 Year Fixed – ditto above, but over 15 years vs. 30.
- ARMS– Adjustable Rate Mortgages. Basically, this loan structure fluctuates according to a fixed structure. This is a rather risky loan.
- One Year Arm – the loan rate changes yearly. Home borrowers who choose this structure often do this when they do not intend to hold onto the property for any great length of time.
- 10/1 ARM – This rate is fixed for the first ten years and then rises after that. It can be a good choice for borrowers who are certain they will be selling within 10 years or are making extra payments to quickly raise equity.
- 5 ARM–same as the 10, but for 5. Far more common than the 10.
- 2 Step Mortgage – has one rate for a certain number of years and another for the remaining years.
- Balloon Mortgages – these last for a much shorter time and operate much like a fixed-rate. For the first part of the mortgage, the borrower is predominantly paying the interest and then pays the remainder of the note at the end of the term. This can be extremely risky and is most often seen in construction loans.
- Interest Only Mortgages – RARE. Not to mention risky. And very little benefit. If you need to do this, you may need to reconsider renting for the time being.
- Loans with Pre-Payment Penalties – this can be a part of any loan program and you should always ask your lender about it to be sure you will not incur it.
OTHER LOAN PROGRAMS AND GOVERNMENT ASSISTANCE PROGRAMS
- Teacher Next Door Program – HUD developed this program to encourage homeownership among educators in low to moderate-income areas.
- Good Neighbor Next Door Program – program designed to encourage homeownership among civil servants such as teachers, policemen, and firemen.
- HUD’s Home Program – available to low-income buyers in certain qualifying areas.
- ADDI – American Dream Down payment Assistance Initiative is available for first time home buyers buying a single-family, residential home. Income restrictions exist; a buyer cannot have an annual income in excess of 80% of the median for the area.
- Zero Down Payment Act – eliminates the down payment requirement with FHA for families who can easily afford the monthly payments but do not have the cash reserves for a down payment. The lender is charged a higher fee for insurance which may deter many lenders from offering it. Contact HUD for more information.
- EEM – stands for Energy Efficient Mortgage Program and is another loan type offered through FHA. This can be useful to any home buyer who is looking to roll the cost of any energy improvements into the loan. This is insured by HUD.
- 203K – This is an FHA loan designed to rehabilitate distressed properties. Certain qualifications must be met, primary residency being one.