If you’re new to the home buying process, you may have heard about a little thing called PMI private mortgage insurance when shopping for a mortgage. What exactly is PMI? Should you be worried about PMI?
For this discussion, we’ll be looking at two of the most common loan types conventional and FHA. The minimum down payment required for a conventional loan is 5% and an FHA loan is 3.5%. For conventional loans when a buyer wants to purchase a home and puts down less than 20% of the home’s loan to value (LTV) ratio. The lender will require the buyer to pay for private mortgage insurance (PMI), which is an insurance policy that protects the lender in the case that a buyer defaults on the loan. Over time once the buyer has paid down the loan to achieve an 80/20 LTV ratio, the PMI will drop off.
For an FHA loan, regardless of the amount put down, it will carry PMI. This is because an FHA loan is federally guaranteed by the government that if the buyer were to default the government will cover the loan. FHA loans were created for borrowers with fair credit scores that can’t qualify for conventional loans or can only get high rates with a conventional loan. With the government’s guarantee to cover the loan, lenders can now offer loans to buyers who may not have the best credit. One of the downsides, however, is that PMI stays with an FHA loan forever. The only way to remove PMI would be to refinance out of the FHA loan to a conventional loan. Ideally, this would be a few years later once a buyer’s credit score is improved and the home has achieved the 80/20 LTV ratio.
How much does PMI add to your monthly mortgage payments? It can vary anywhere from an extra $50-$300/mo or more. The exact amount is dependent on your credit score and how big of a downpayment. If you put down the minimum expect it to be higher, if you’re able to put down 10% or 15% of the purchase price, then it would be less. Every buyer’s situation is unique, so it’s best to consult with a loan officer. If your credit score is on the borderline between fair and good or good and very good, a loan officer may be able to help strategize ways to improve your credit score before applying for a home loan to lower your PMI costs.
Should you be concerned about PMI? Yes, but don’t let it be a deal-breaker between deciding to buy a home now or waiting until you have 20% to put down. The truth is many buyers out there cannot afford to put down 20% on a home purchase, even if they have that much in the bank. That’s a lot of money to drop all at once and it could take years for you to save up that 20%. The longer you wait, home prices and interest rates will keep increasing which in turn could make your 20% a moving target. Instead, factor in PMI as another cost for owning a home into your monthly affordability calculation. If you have the credit, enough downpayment, and can afford the monthly payments, definitely consider purchasing now to take advantage of the still historically low interest rates, lock that in for 30 years, take advantage of being able to get a loan that will fund you 95-96.5% of the home’s purchase price, and all the while your home should continue to appreciate in value over the long term. So becoming a homeowner sooner vs. waiting can offer many benefits including building up that home equity, possible tax deductions, hedging against inflation, and achieving the American dream of homeownership.