What Is PMI (Private Mortgage Insurance) And How Does It Work?
Private Mortgage Insurance insures the lender for 20% of the loan in the event that the borrower defaults. Keep in mind that even though the borrower pays the monthly premium on the insurance policy, this does not protect the homeowner if they default on the loan. In the event that the borrower does default on the loan, the lender will sell the property to cover the debt, and will then be reimbursed by the private mortgage insurance company up to the amount of the policy value.
PMI Options: Upfront, Financed or Monthly Payments?
- Financing PMI into your loan generally carries with it an overall lower payment than a mortgage payment with a PMI payment attached.
- Upfront payment of PMI means you pay this fee upfront and have no monthly PMI premium obligation.
- Paying your PMI premiums monthly involves paying the PMI premium in in addition to your mortgage payment.
As you can see, you have the option of paying PMI upfront, financing it into your loan or monthly payments through escrow. PMI does not build equity, however, once you have 20% equity in your home you no longer have to pay private mortgage insurance. Of course, you will need to decide based on your specific situation which option is best for you as there is no way to tell how long you will be paying PMI. This depends on how your home appreciates; does it appreciate quickly satisfying the 20% requirement or remain flat? Depending on your scenario, you may be paying private mortgage insurance for a long time.
Is Paying PMI Upfront At Closing Generally Less?
Paying PMI upfront at closing presents the greater likelihood that you will pay out a larger amount over the life of the loan than if you were to pay it monthly. This is due to real estate generally appreciating over the long haul even with market corrections. Furthermore, with each amortized mortgage payment you build equity in your home. This means that you are more likely to achieve 20% equity in your home sooner thereby halting PMI payments than if you pay it all upfront for the term of your loan. PMI premiums paid upfront aren't returned to you when you achieve 20% equity in your home, so it is best to consider how long you will own the home, the type of loan you get and market conditions as this will help to determine if paying PMI upfront or over the life of the loan will be worth it.
PMI Tax Deduction
PMI was originally only deductible if you purchased your home in the calendar year 2007. So even if you bought your home in 2006 or earlier, you would not qualify for the tax deduction, however, the PMI deduction was extended through 2010. Also, keep in mind that while PMI premiums are deductible, this is based on your yearly income. If you make less than $100,000, then you can deduct the PMI payment just as you would your mortgage interest payments. For incomes between $100,000-110,000, a portion of it is deductible. For incomes above 110,000, no deduction is allowed.
4 Tips to Avoid PMI
- Put 20% down
This is of course, the most obvious way to avoid PMI. By putting 20% down you become less of a risk to the bank as they will only be loaning you 80% of the loan while you fork over the other 20%.
- Piggy Back Loan: 10% down
You put 10% down, the banks you the other 10% and 80% in two separate loans. While this avoids PMI, the smaller loan at 10% often carries a higher interest rate and a shorter term, however this higher interest rate is also tax deductible.
- Government Insured Mortgage
FHA and VA mortgages have the option of low cost or free PMI depending on whether you meet certain criteria. Since the government insures the mortgage, this makes it easier for you to qualify for the loan.
- Roll PMI into the Mortgage
This option allows you to avoid PMI altogether by accepting a slightly higher interest rate which covers the cost of the insurance policy. However, while this carries a larger mortgage payment, the extra interest is also tax deductible for the borrower, so this is a win-win situation for both the buyer and lender.
As always, your individual situation determines your course of action, if you have questions, feel free to contact Daniel, our owner and meet with him over coffee to discuss your plan and any questions you may have.