Private Mortgage Insurance (PMI): What it is and How it Works
Private Mortgage Insurance
When it comes to conventional financing for a home, expect to hear, "Private Mortgage Insurance" at some point (or PMI for short). PMI is the insurance on a loan which protects lenders from default. It is based on a percentage of the loan amount--- NOT the purchase price.
Private Mortgage Insurance is determined by 3 factors:
- Down payment
- Credit score
- Debt-to-Income ratio
How PMI Works
If the down payment on a home is below 20% equity, there will be Private Mortgage Insurance. It is just a question of how high or low the rate will be. And that will depend on the credit score, the down payment amount, and the debt-to-income ratio.
In other words, if it is a low credit score and/or a high debt-to-income ratio, expect the PMI rate to be higher. So the lender will have that added protection.
Understanding PMI Payments
Private Mortgage Insurance payments are made on a monthly basis alongside the mortgage. Eventually, PMI goes away once you've paid down 20% of the loan or you reached 80% LTV (loan to value ratio)
After two years of PMI payments, there is an option of getting an appraisal. If it happens be in a market where values are drastically rising, then it is possible to have reached that 20% equity. It is also worth noting-- the loan estimate received will often give a timeframe of when the lender believes the PMI will drop off.
An appraisal can be requested again after two years.
The Appraisal Criteria
As mentioned above, when requesting an appraisal on a home with hopes of ending PMI, the payments will need to be at 20% equity OR below 80% Loan-To-Value.
Loan-To-Value = (Amount owed on the loan / Value of the Asset). That is why the down payment on the loan plays such a big part in determining PMI rates. If that initial LTV is lower, then the lender is more comfortable with securing the loan.
Private Mortgage Insurance Buyouts
There can also be the prospect of buying out the PMI. For example, putting a 15% down payment on a loan can make it worth spending the extra money on buying out the Private Mortgage Insurance outright. This would be as opposed to that extra 5% on initial down payment. And it also requires having good credit for approval.