Before buying a house, you should save a lot of money for a 20% prepayment. If you can’t, it’s a safe bet that your lender will force you to take out private mortgage insurance (PMI) before you sign up for the loan if you’re taking out a standard mortgage. The purpose of the insurance is to protect the mortgage company if you default on the note.
The Federal Housing Authority has a similar mortgage insurance premium requirement for those applying for FHA loans, with slightly different rules. This article is about PMI, but the reasons to avoid it are related to both types of loans.
PMI seems like a great way to buy a home without saving as much as possible for a down payment. Sometimes it’s the only option for new home buyers. However, there are good reasons why you should try to avoid PMI. Here are six, plus one possible way for those without a 20% advance to put it all side by side.key takeaways
- PMI insurance aims to protect the mortgage company if you default on the note.
- However, there are good reasons why you should try to avoid PMI.
- In some circumstances, PMI can be avoided by using a pig mortgage.
Six Reasons to Avoid Private Mortgage Insurance
1. Costs
PMI typically costs between 0.5% and 1% of the total loan amount on an annual basis. That means you could pay up to $1,000 a year, or $83.33 a month, for a $100,000 loan, assuming a 1% PMI rate. However, according to Zillow, the median US home listing price is nearly $250,000 (as of September 2020), meaning families could spend more than $3,420 a year on insurance. That’s as much as a small car payment!
2. It is no longer deductible.
Until 2017, PMI was still tax-deductible unless the married taxpayer’s adjusted gross income was less than $110,000 per year. This meant that many dual-income families were left out. The Tax Collection and Jobs Act of 2017 (TCJA) abolished the mortgage insurance premium deduction in its entirety, effective in 2018.
3. Your heirs get nothing.
Many homeowners hear the word “insurance” and assume that their spouse or children will receive some monetary compensation if they die, which is not the case. The sole beneficiary of such a policy is the lender, and the proceeds are paid directly to the lender (not indirectly to the heirs first). If you want to protect your heirs and provide them with living expenses in the event of your death, you will need to obtain a separate insurance policy. Don’t be fooled into thinking that PMI will help anyone other than your mortgage lender.
4. Withdraw money
Homebuyers who reduce less than 20% of the sale price will have to pay PMI until the home’s total value reaches 20%. This would take years, and you are giving a lot of money. To put the cost into a better perspective, if a couple with a $250,000 home took the $208 a month they were spending on PMI and invested it in a mutual fund that earned an 8% CAGR, that money grew. To $37,707 (assuming no taxes were deducted) over ten years.
5. Difficult to cancel
As mentioned above, generally, when your equity is above 20%, you no longer have to pay PMI. However, removing the monthly charge and not making the payment is easy. Many lenders require that you write a letter requesting that the PMI be canceled and request a formal appraisal on the home before it is canceled. Depending on the lender, this can generally take several months, and PMI is still due.
6. Payment in advance and in advance
One last item worth mentioning is that some lenders require you to maintain a PMI contract for a designated period. So even if you’ve reached the 20% threshold, you may still be required to pay mortgage insurance. Read the fine print of your PMI contract to find out if this is the case.
PMI does not automatically cancel until your equity reaches 22%.
How to avoid PMI
In some circumstances, PMI can be avoided by using a pig mortgage. Here’s how it works: If you want to buy a house for $200,000 but only save a lot of money with a 10% down payment, you can do an 80/10/10 deal. You get a loan for a total of 80% of the property’s full value, or $160,000, and then a second loan, called a piggyback, at $20,000 (or 10% of the matter). Finally, as part of the transaction, you deposit the final 10%, or $20,000.
By splitting the loans, you may deduct the interest on both and avoid PMI altogether. Of course, there is a catch. The terms of swine loans are often risky. Many are adjustable-rate loans, have balloon provisions, or mature in 15 or 20 years (instead of the more standard 30-year mortgage).
Baseline
PMI is expensive. Suppose you think you won’t be able to reach 20% of home equity in a few years. In that case, it’s probably wise to wait until you can make a more significant down payment or consider a cheaper home, which will result in a 20% reduction—.% more affordable payment.