You've probably heard that it's a good idea to put down 20% of your home's purchase price when you're taking out a conventional loan. But if you live in housing markets where starter homes go for, $500,000, that may not be possible. Or maybe you're eager to become a homeowner and haven't been working long enough to save up a 20% down payment. You may choose to move forward with your purchase rather than continue throwing money away on rent.
It's certainly possible to buy a home without making a full 20% down payment. But if you go that route, you'll face an added expense that could make homeownership more expensive for you: private mortgage insurance.
What is private mortgage insurance?
Mortgage lenders typically require that borrowers buy private mortgage insurance, or PMI, when you they put down 20% of the home's price. If you buy a $200,000 property, you'd need a $40,000 down payment to avoid PMI.
When you hear the word "insurance," you might assume that PMI is designed to protect you, the buyer. But that's not the case. The purpose of PMI is to protect your lender if you're unable to keep up with your mortgage payments and your home winds up in foreclosure.
How much does private mortgage insurance cost?
The cost of PMI varies, but is generally 0.5% to 1% of your loan amount per year. That might seem like a pretty small percentage. But if you're talking about a $300,000 mortgage, that's an extra $1,500 to $3,000 a year in added payments. The cost of PMI is typically rolled into your monthly mortgage payments.
But you may have the option to pay your entire PMI premium up front when you close on your mortgage. In doing so, you’ll generally pay less than what you would by submitting a monthly premium over time, which is why some buyers go this route.
You can help keep your PMI costs manageable by applying for a mortgage once your credit score is in decent shape. You’re probably aware that the higher your credit score, the more favorable an interest rate you’ll snag on your mortgage. The same holds true for PMI, so in this regard, having strong credit can help.
Will I be stuck with private mortgage insurance forever?
Just because you start out paying PMI doesn’t mean you’ll be locked into those added payments for the entire life of your loan. You’ll need to continue paying PMI until you attain 20% equity in your home. (By "equity," we’re talking about your home’s value minus the amount you owe on your mortgage.) But that’s a process that could take a long time, especially if your down payment is pretty low.
Furthermore, you’re not guaranteed to have PMI removed once you hit that 20% equity threshold. Many lenders, in that situation, require you to get a home appraisal proving that your property’s value is high enough to have your PMI canceled. That could be a lengthy process, during which time you’ll need to keep paying those PMI premiums.
And lenders aren’t required to let you off the hook from paying PMI until you attain 22% equity in your home.
Is private mortgage insurance worth it?
Private mortgage insurance could be the thing that enables you to become a homeowner without having to wait to save up a 20% down payment. If you’re itching to own, and you earn enough money to support the cost of PMI on top of your monthly mortgage payment, then it may be worth it.
You might also consider paying PMI on a mortgage for an investment property. If that property generates enough income, you may wind up with more than enough money coming in to cover your mortgage expenses, including PMI. And if you’re able to command enough rent, you might manage to shake that PMI quickly as you use your proceeds to pay down your mortgage and increase your equity.
However, if you’re in a situation where you’re facing PMI, you might stop and ask yourself why you’re in that position. Is it because you’re doing well financially but just haven’t saved enough for a down payment? Or is it because you really can’t afford your home in the first place and it’ll take years to build enough equity to reach that 20% threshold?
If you’re dealing with the latter, it’s probably worth holding off on homeownership until you’re in a better place financially. Remember, if you’re stretching your budget to afford to your home, the last thing you want to do is make your monthly mortgage payments more expensive. But if you sign up for PMI, you’ll be doing just that.
The bottom line on private mortgage insurance
PMI isn’t always a terrible thing. If you can afford it, it’s a reasonable solution when you don’t have a larger down payment available. Just be aware that it can be costly and difficult to shake. But if you manage your mortgage accordingly, you won’t be stuck with it forever.