Private mortgage insurance, also known as PMI, protects the lender in case the borrower defaults on their loan. Borrowers tend to try to avoid PMI because it is expensive, and it does not benefit the borrower who pays for it. On the other hand, some borrowers simply cannot buy a house without getting private mortgage insurance. PMI is applied to the outstanding principal when a borrower puts down a payment of less than 20%, and it generally lasts until the loan-to-value (LTV) ratio drops below 80%. If a borrower tries to calculate private mortgage insurance premiums for their loan, they will soon realize that it is expensive, so they should try to avoid PMI as much as possible. If a borrower already has private mortgage insurance, there are ways for a borrower to stop paying for it.
Private mortgage contracts, just like mortgage terms are fixed and need to be renegotiated once the current private mortgage insurance expires. The length of a single private mortgage insurance contract is usually 1 year, but it can be as short as 6 months and as long as 3 years. Generally, private mortgage insurance companies offer multiple terms to fit the largest number of borrowers. This flexibility in term lengths is due to the fact that most mortgage lenders do not require private mortgage insurance once the LTV on the loan reaches 80%, which is equivalent to putting a down payment of 20%.
It is important to note that private mortgage insurance companies may also provide different rates for different term lengths even if the financial situation of the borrower does not change. For example, if a borrower gets private mortgage insurance for 1 year, they may have a better rate if they got private mortgage insurance for 6 months. Generally, mortgage insurance companies prefer issuing longer-term insurance because it provides a larger payoff for a similar amount of work. A borrower who is not planning to surpass the LTV ratio of 80% on their mortgage any time soon, should opt in for longer-term private mortgage insurance to save some money down the road. Getting a short-term PMI is worth only when a borrower is close to lowering their LTV to below 80%. Once the borrower reaches the LTV of less than 80%, their lender may not require PMI anymore. This means that the borrower does not have to pay PMI premiums once LTV is below 80%. For example, if a borrower expects their LTV to be below 80% in 6 months, they may be better off getting private mortgage insurance for 6 months rather than for 1 year.
It is never in the interest of a borrower to pay PMI premiums because it does not protect them, but it protects the lender. Private mortgage insurance can also be very expensive and range from 0.5% to 1.5% of the outstanding principal. For example, if a borrower gets a PMI at a rate of 1% on a mortgage with the outstanding principal of $500,000, the borrower would have to pay $5,000 extra to cover the annual cost of insurance. Even though some people may find enough cash to put a down payment of 20%, many people who cannot cover such a large down payment, are required to get private mortgage insurance that adds up to their expenses.
There are some ways to avoid private mortgage insurance partially or even fully over the lifetime of the mortgage as well as avoid PMI completely. Depending on the borrower’s situation, they may be eligible for government-backed loans that may not require mortgage private insurance. FHA, USDA, and VA loans are different types of mortgages that are backed by US government agencies. Since they are backed by US government agencies, the lenders who issue these loans consider these loans less risky than conventional loans. In addition to that, government-backed loans usually do not require private mortgage insurance, but they may still require some kind extra of funding.
FHA loans are backed by the Federal Housing Administration, and it provides favorable terms and rates for eligible borrowers. FHA loan has its own insurance for borrowers with loans that have an LTV of more than 80%. Unlike private mortgage insurance, mortgage insurance premiums on FHA loans are lower and usually range from 0.45% to 1.05% depending on risk factors as well as the term length of the insurance and the LTV ratio.
USDA loans are backed by the US Department of Agriculture, and these loans offer favorable terms and conditions for borrowers who buy an eligible property in a rural area of the United States. USDA loans do not require any insurance, but all USDA loans have an annual fee of 0.35% of the loan balance. This fee is much lower than mortgage insurance premiums for conventional and even FHA loans, but it is important to note that the annual fees are charged on USDA loans throughout their lifetime.
Lastly, VA loans are backed by the Department of Veteran Affairs. VA loans are some of the cheapest loans a borrower can get, but it also has strict eligibility requirements. The most important requirement to be eligible for a VA loan is that a borrower must be an eligible veteran or a serviceman. VA loans also do not require private mortgage insurance, but they do require a one-time funding fee of 1.75% of the loan amount. Even though 1.75% is a much larger fee than the mortgage insurance fees paid on other loans, it is important to understand that VA loans require the fee to be paid once and not annually.