If you are one of the many people who took advantage of the free-flowing credit offers (you know, during the early 2000’s when people just
asked wanted to know “how much I can borrow” without a second thought) to purchase a home with less than the standard 20% down payment, you are undoubtedly aware that you are paying extra money each month in addition to your principal, interest, and in some cases taxes and interest.
What many do not understand, however, is just what those extra payments are for, why they are being charged, or how to get rid of them. And, the interesting thing is that for all those who tried to use a mortgage payments calculator, none of these tools ever mention this additional cost in the calculation, nor do many financial articles that dealt with real estate or mortgages.
So, for the uninformed, those extra dollars represent private mortgage insurance or PMI.
What is PMI?
PMI is the money that mortgage lenders charge as a hedge against homeowners falling behind on their payments and eventually defaulting on the loans. It isn’t an insurance for the benefit of the borrower, but rather a protection for the lender; a fee that is charged on loans which, when originated, represented more than 80% of the sales price of the home. It used to be that banks would not loan money for the purchase of a home if the prospective buyer could not afford to pay at least 20% of the property’s sales price up front. PMI was established to help potential homeowners reach their goals of homeownership faster by enabling them to put less money down and pay this insurance cost to cover the lender’s increased risk.
How to remove PMI
Since PMI is an insurance coverage for paying less than the standard down payment, it is going to be part of your mortgage for some time. There are, however 3 ways to have the insurance eliminated from your payment:
Cancellation: This is a manual process by which you put in a request with the mortgagor to have the insurance payments removed. To qualify, the account must reach a loan-to-value (LTV) ratio of 80%, but there is a catch. The catch is, the basis for this calculation is the original purchase price of the home, or the current appraised value of the home, whichever value is less. What this means is that if you want to take the initiative to remove the PMI from your loan account, you need to obtain an appraisal, and if the current value is less than the original purchase price of the home, then the loan balance must be at most 80% of this new value. Should the appraisal come in higher than the original purchase price, then the balance has to be at most 80% of the that original price. In a bad economy, this option is less likely to occur since most homes have been devalued in many areas of the country.
Automatic Removal: On July 29, 1999, the new Homeowner’s Protection Act of 1998 was enacted which by law, made this an automatic process that should require no action on your part. If you stay current on your mortgage, the lender is legally required to automatically remove the PMI from your account when the balance reaches 78% of the original purchase price. The lender has 30 days from the date your account reaches this 78% ratio point. Additionally, if there are any unearned premiums charged by the lender they have 45 days from that date to return those premiums to you.
Final Termination: If, for some reason, neither of the first two situations occurred, the lender is required to terminate the insurance the month after the midway point of the loan. Basically, if you are on a 30 year loan which has 360 payments and have not had the insurance cancelled, then by the month following the 180th payment (the midpoint of the loan’s lifetime), the coverage should be removed.
A point of caution
There have been many people who say that making extra payments on loans, or having an appraisal improving the value portion of the LTV equation will accelerate the process of removing PMI. Unfortunately, the wording in the Homeowners Protection Act is quite clear, and contradicts those claims [for automatic cancellation]. The document (on page 2) states in plain English that the thresholds for determining LTV is “based solely on the initial amortization schedule, in the case of a fixed-rate loan,or on the amortization schedules, in the case of an adjustable-rate loan, regardless of the outstanding balance”. What this means is that on no date other than the date determined by the original amortization schedule when the loan reaches the desired LTV can the PMI be [automatically] cancelled.
How you can avoid PMI
There are 2 was to avoid having to pay for PMI on a mortgage:
- Pay 20% of the purchase price of the home up front in the form of a down payment; and
- Obtain a second loan (commonly referred to as piggy-backing” in order to come up with the required down payments
Which method will work best for you will depend on your situation. In some cases, it will be impossible to come up with the 20% down payment, and sometimes obtaining a piggy-backed loan may require significantly higher interest rates, which will make make carrying PMI a more affordable option. The best way to approach the situation is to have all of the pertinent information available and take the time to analyze all of the options to see what best fits your financial plans.