If you’re planning to take out a home loan you may have heard the phrase ‘private mortgage insurance’ bandied about. So what is it and who needs it?
In general, a lender will require you to obtain private mortgage insurance when your home loan is worth more than 80 percent of the purchase price of the home.
Basically, most lenders consider the ideal borrower as someone who can fund 20 percent of the home price. This shows that the borrower has significant ‘skin in the game’ – by investing a significant amount of money in the home they demonstrate a high level of commitment to the home and to meeting their loan repayments.
Moreover, it means that should the borrower default on the loan they will have equity in the home which they can be sold and used to pay off a good chunk of the outstanding mortgage. Accordingly, by lending to such a borrower the bank is taking less of a risk than if they lend the same amount of money to a borrower without such equity.
However, the bank won’t necessarily refuse to lend to you if you have less than a 20 percent down payment. What they will do to reduce their risk is to require you to purchase private mortgage insurance!
Private mortgage insurance or ‘PMI’ provides security for the bank in assuming the risk associated with lending to someone with less than a 20 percent down payment. This is because if the homeowner purchases PMI and they default on the loan, the insurance company will pay off the remaining balance of the loan. In turn, this means that the bank will not lose money if the borrower cannot pay their mortgage payments and end up in foreclosure.
The Federal Government has established regulations governing the imposition of PMI since it presents a significant an additional expense for consumers. In particular, the Homeowner’s Protection Act specifies particular rules that lenders must follow in relation to private mortgage insurance. These rules are designed to protect the borrowers and save them money. For instance, when a lender requires you to obtain PMI they must inform you of the amounts you must pay, when you must pay these amounts, the date you can stop paying them, when the PMI will automatically be canceled, your rights to terminate the PMI, and a phone number you can call to cancel the insurance.
Although many home buyers who borrow more than 80 percent of the purchase price of a home must buy PMI, there are also other circumstances where you will also have to pay for such insurance. The most common instance is where you have a poor credit score. A poor credit score means that you are a higher ‘credit risk’ to the bank, such that they will desire you to have PMI.
So how much does private mortgage insurance cost and when do you need to pay it? Well, you will typically be required to pay around.5 percent of the total loan value for PMI. What’s more, a lender will usually want the entire first year’s premium up front at the close of the home purchase. So if you have a loan of $200,000, your PMI will cost around $1,000. In most cases, you will need to continue paying for the private mortgage insurance until you have paid at least 20 percent of the loan value down. Once you have built this level of equity in the home you will no longer be required to pay for the insurance.
Despite the additional expense presented by PMI and the obvious attraction of having at least a 20 percent down payment PMI is not all bad news. In fact, it may be a small price to pay to get into home ownership earlier rather than later. However, it’s best to discuss the best strategy whether it’s saving a larger down payment or using a smaller down payment and buying PMI with your mortgage planner.