You may have heard the term PMI thrown out there when discussing home loans and down payment amounts.   Here is a quick lesson on what it is and how it affects your mortgage payment.

PMI stands for Private Mortgage Insurance and is an amount added to your monthly loan payments on conventional loans, when you put less than 20% down on a purchase or have a loan to value that is higher than 80% on a refinance.  The insurance part of the term is a little misleading as it doesn’t insure the borrower, it insures the lender against the borrower defaulting on the loan.

Why is 80% the limit to avoid having it added to your payment?

Over time the data has shown that a lender receives about 80% of the value of a home that is sold through foreclosure, so any money leant out above that limit is a loss, so the industry has used PMI to cover itself on loans above that 80% loan to value threshold.

It’s important to note that the closer your Loan to Value (LTV) is to 80%, Say 83% LTV versus 95% LTV, the lower your monthly mortgage insurance will be.  So, even if you don’t have the full 20% to put down, you can lower the amount of PMI that is added to your payment AND the lower the LTV, the sooner that monthly fee will drop off.  Conversely the higher your Loan to Value (LTV) the higher the monthly fee will be and the longer it will take for you to be eligible to drop it off.

Credit score matters.

Just like with interest rates, your credit score along with your Loan to Value (LTV) will affect how much your monthly PMI fee is.  There are also adjustments for the type of loan you are taking out (purchase, refi, cash-out refi), loan amount, debt ratio and if the house is a primary residence or a 2^nd home.  All these details add risk to the loan and the probability the borrower might default so the monthly amount adjusts depending on the specific scenario.  Ideally the lowest monthly PMI fee would be a result of an LTV under 85%, a fico score over 760, low debt ratio, for a primary residence and a conforming loan amount.  So, the details of your scenario will matter.  Due to the above reasons, a borrower with a lower fico score, high LTV, and a higher-than-average debt ratio will be looking at FHA loans.  FHA loans do have monthly mortgage insurance, but everyone gets the same monthly fee no matter what the details of their scenario. We will discuss this another time.

How can you get the PMI removed?

There are 3 ways to get PMI removed from your loan payment: 1. You can refinance your loan once the home’s value has increase and the loan balance has been paid down to bring your loan to value % to 80% of below. 2. The lender will automatically drop the PMI off once you have hit 78% of the value from the time you did your loan.  example: you paid 600K for your home and took out a loan for 510K (85% loan to value at the time of purchase).  Once your loan balance gets to 468K (78% of the value at the time of purchase) the lender will automatically remove the monthly PMI.  3. Some lenders will allow you to provide them with an appraisal that documents the Loan to Value is below 78% and request that they drop the PMI off. (Not all lenders allow this, so this isn’t the surest way to get PMI removed, but it’s always worth a try once you hit that 78% LTV level)

Private Mortgage Insurance isn’t the worst thing, as it lets you finance a home with less than 20% down. Of course, if you have the funds available for the larger downpayment, you can avoid it.  It really depends on your scenario. Sometimes it makes sense to keep some money in the bank and pay a little PMI for a short time, so you don’t invest every penny into your house.  I always advise keeping some funds for a reserve, an emergency fund, or for any repairs you may want to make once you move in.