When a borrower takes out a conventional home loan, private mortgage insurance may be an extra, built-in expense that the borrower has to pay. Private mortgage insurance is typically required when the borrower has a conventional loan and makes a down payment that is less than 20 percent of the purchase price. It serves to protect your lender should you fall behind on the monthly mortgage payments. Private insurance companies oversee these policies and the primary lender arranges them. The requirement of private mortgage insurance or PMI also comes into play when a loan is being refinanced—when the equity is less than 20 percent, then PMI is often an obligation.
Most financial advisors would agree that prospective borrowers should go the extra mile to avoid paying for PMI if possible. Investopedia contributor, Glenn Curtis explained how the cost of PMI can add up in a hurry. As a rule, the extra cost for this type of insurance runs between 0.5 percent to a full 1 percent of the loan total on an annual basis. Considering the National Association of Realtor’s figure for the average price of a single-family home is around $230,000, that could mean an extra $2,300 a year.
Furthermore, PMI premiums may not be tax deductible. Whether or not you can deduct your PMI premiums usually depends on your income, but other factors may be involved.*
When a borrower puts down less than 20 percent, they are subject to pay for the PMI until they have accrued 20 percent in home equity. Financial planners again would agree that this is a tough way to get ahead. Curtis cites this example: “if a couple who own a $250,000 home were to instead take the $208 per month they were spending on PMI and invest it in a mutual fund that earned an 8 percent annual compounded rate of return, that money would grow to $37,707 (assuming no taxes were taken out) within 10 years.
One way to avoid paying ongoing PMI premiums is to pay the PMI upfront. This would likely take place in cash at the time that the mortgage is initiated. Many lenders offer discounts to borrowers who can swing this. Some lenders offer borrowers the option of “buying out” the PMI with a slightly higher interest rate. This is sometimes referred to as lender-paid mortgage insurance. The benefit to this arrangement is that, over the course of 25-30 years, the monthly cost is relatively low.
In order to avoid paying PMI altogether, there are two main options: the borrower must either a) make at least a 20% down payment, or b) opt for a mortgage that does not have PMI, such as a USDA loan or VA loan.
Many who have been faced with the prospect of paying PMI premiums opt for what are known as “piggy-back” loans, also known as an 80/10/10 agreement. This type of loan arrangement allows a borrower to take out multiple loans simultaneously. The major one is for 80 percent of the home’s value, and the other loan covers whatever money is needed for the 20 percent down payment. This type of loan is frequently used as an alternative to having to pay private mortgage insurance. When the loan is split, the homeowner may be able to deduct interest on both loans, thus, avoiding PMI completely. However, keep in mind that piggyback loans carry a certain amount of risk. Curtis explains that, “many are adjustable-rate loans, may contain balloon provisions and are due in 15 or 20 years (as opposed to more conventional loans, which are due in 30 years).”
*Consult a qualified tax professional.