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If you’re a first-time homebuyer, you’re probably going to run into mortgage insurance, often called PMI. You typically pay mortgage insurance on most home loans if you make a down payment of less than 20 percent of the purchase price.
Though you can’t shop around for PMI for a mortgage like you would for homeowner’s insurance, you have options. Some of your choices regarding a home loan will significantly affect what you pay for PMI, so it’s important to know what those options are and have a basic understanding of mortgage insurance overall.
How Does PMI Work?
PMI stands for private mortgage insurance. It helps ensure that your lender can recover its money if you default on the loan and go into foreclosure. It’s often charged on conventional loans, the term used for mortgages backed by Fannie Mae or Freddie Mac.
Mortgage lenders like to have a 20 percent down payment to provide themselves with a financial cushion against default – that’s money in hand that can cover the cost of foreclosure and guard against the possibility the home may decline in value.
They’re usually willing to accept a lower down payment, representing a greater risk. So, they require PMI to cover the difference between your down payment and the 20 percent equity mark. For example, if you put 5 percent down, your PMI insurance will pay the lender 15 percent of the home’s sale price if you default on the mortgage.
Even though you pay the mortgage insurance premiums, it’s the lender who’s being insured. That might not seem fair, but the PMI cost represents the added risk the lender is taking on with a smaller down payment – so you pay for it.
How Much is PMI?
Mortgage insurance rates for PMI vary according to several factors, primarily your credit score and the amount of your down payment. For most borrowers, mortgage insurance premiums will be an annual fee of 0.58% to 1.86% of the original loan amount per year, according to the Urban Institute’s Housing Finance Policy Center.
PMI may be higher for loans over the conforming loan limit (jumbo loans), manufactured homes, second homes, investment property, down payments less than 5 percent and borrowers with poor credit.
» MORE: See today’s refinance rates
PMI vs. FHA Mortgage Insurance Premiums
FHA mortgage insurance, known as a Mortgage Insurance Premium (MIP), is structured differently than PMI. With an FHA home loan, you pay an initial mortgage insurance premium of 1.75 percent of the loan amount at the time of the loan, and then an annual fee, which for most borrowers is 0.85 percent of the loan amount, billed as a monthly charge on the mortgage statement. That figure can be as high as 1.05 percent on jumbo loans and as low as 0.45 on 15-year mortgages.
Aside from the different fee structures, there are some significant differences between PMI and FHA mortgage insurance. For one, FHA mortgage insurance premiums are not tied to your credit score, unlike PMI. The big difference though, is that it’s easier to cancel PMI once you acquire sufficient home equity.
You can have PMI canceled once you reach 20 percent home equity, either by paying down your loan or through an increase in property value (an appraisal may be required). Your lender must also cancel PMI automatically when your loan balance falls to 78 percent of the purchase price through scheduled amortization.
FHA mortgage insurance premiums cannot be canceled if you put less than 10 percent down on a 30-year mortgage – you must carry them for the life of the loan. You can get around this by refinancing once you reach 20 percent equity, but that’s considerably more costly than simply being able to cancel it as you can with PMI.
VA Loan Mortgage Insurance and USDA Loans
Mortgage insurance isn’t required for VA loans. However, VA loans have a one-time fee for certain borrowers known as the VA funding fee, which acts like mortgage insurance.
The same is true for USDA Rural Development Loans, which are home loans for borrowers with low-to-moderate incomes who currently lack adequate housing.
Is PMI Tax-Deductible?
As of 2023, Private Mortgage Insurance (PMI) is no longer tax deductible. This change applies to premiums paid after December 31, 2021. Previously, the mortgage insurance deduction was available for eligible homeowners for the tax years 2018 through 2021, offering a financial benefit to those paying PMI. However, this deduction expired and is not applicable for the tax year 2022 and onwards, unless future tax guidelines reintroduce it.
About Lender-Paid Mortgage insurance
A variation on PMI is lender-paid mortgage insurance or LMPI. In this case, the lender self-insures the loan by charging you a somewhat higher mortgage rate, usually a quarter to half a percentage, rather than having you pay mortgage insurance premiums.
The big advantage of LPMI is that it’s tax-deductible since the cost is part of your mortgage rate – and you don’t have to worry about Congress extending it. The downside is that you can’t cancel it once you reach 20 percent equity – it’s a permanent feature of your loan that you can only get rid of by refinancing. However, it can be an attractive option for borrowers who expect to move again within a few years.
Sometimes, lenders will charge LPMI as a single fee at closing. In that case, you don’t get the tax deduction because it isn’t part of your mortgage rate.
Using a Piggyback Loan to Avoid PMI
You can sometimes avoid paying for PMI or FHA mortgage insurance using a piggyback loan. This type of second mortgage covers the difference between your down payment and 20 percent, so you don’t have to pay mortgage insurance premiums on the primary loan.
For example, if you put 5 percent down, you might take out a piggyback loan for another 15 percent to avoid paying PMI insurance on the primary loan. The interest rate on the piggyback will be higher than on the primary mortgage, but it’s still tax-deductible and may cost less than you’d pay in mortgage insurance premiums.
This arrangement was fairly common before the 2008 crash but is rarely used or available and only for borrowers with good credit.
Is PMI Worth It?
Some financial writers say you should avoid PMI/mortgage insurance and instead strive to make a 20 percent down payment. That works if you can find a more modest property to afford 20 percent down – which is rarely the case in the current housing market.
For many aspiring homeowners, it would take years to save up enough to put 20 percent down on any home, let alone a modest but decent one. Making a smaller down payment and paying for PMI/mortgage insurance allows you to own a home and start building equity now rather than paying that same money on rent.
Mortgage insurance can be a useful and cost-effective tool to help you realize your goal of owning a home without depleting your savings or taking a decade or more to save up a large down payment. Knowing how it works and the choices available can help you decide just how much of a down payment you need and will help you narrow down your mortgage options.