As you may have heard, the mortgage industry is undergoing major changes in the requirements it sets for buying or refinancing a home. One of these changes is a homebuyer’s diminished ability to avoid paying Private Mortgage Insurance.
Not to worry, there is a silver lining! But first, let’s review the basics of mortgage insurance.
Mortgage insurance is known by two aliases. The first is Private Mortgage Insurance or PMI, which is typically connected with—but not limited to—mortgages secured by Fannie Mae (FNMA) and Freddie Mac (FHLMC). The second is Mortgage Insurance or MI, which is connected with mortgages that are secured by the Federal Housing
Administration (FHA). For the purpose of this article, my references will be inline with
So, what is the purpose of Private Mortgage Insurance?
Simply put, if you are buying or refinancing a home but contribute less than a 20 percent down payment for a purchase or don’t preserve a minimum of 20 percent equity in the home for a refinance, the lender
requires Private Mortgage Insurance. By ensuring that your home's balance will be paid, this policy protects the lender's money in the event that you default on the mortgage. In other words, if the lender is forced to foreclose on the home, the only way it can recover the remaining mortgage balance is to sell the house.
With a home that has less than 20 percent equity, the likelihood or risk of taking a loss is much greater.
Rewind back to the early 2000s. As lending requirements eased, a qualified homebuyer seeking mortgage financing could buy a home with no money down and was not required to pay PMI. This was made possible
by securing a primary mortgage equal to 80 percent of the home price and then combining that with secondary financing of 20 percent. So, for a $400,000 home price, you could avoid paying PMI by financing only $320,000 on a first mortgage while securing a second mortgage for the remaining $80,000. In theory, this worked for both the first and second mortgage lenders.
Since the first mortgage company is legally paid first upon the sale of the home, its risk or exposure was limited to a comfortable 80 percent. The second mortgage lender, willing to take more risk for a higher rate of interest, was hedging its bets on timely mortgage payments in the rising equity market.
Well, I guess you could say that these bets failed to pay off. And thus, these options have virtually disappeared. In fact, the only option for financing a home with less than a 10 percent down payment for a purchase or 10 percent preserved equity for a refinance is a mortgage that requires Private Mortgage Insurance. Whether you pay the premium annually or monthly, or the lender offers a higher interest rate to effectively pay the premium on your behalf, this is the new frontier for the mortgage industry.
So, I’m sure you’re asking , “How in the world could Private Mortgage Insurance benefit me, or anyone for that matter?”
Although the cost may seem substantial, PMI continues to offer more buyers—especially the next generation of home owners—access to home ownership by allowing down payments as low as 5 percent and even as low as 3.5 percent for a mortgage secured by FHA. The alternative would be a return to the dark ages of banking, where a 20 percent down payment was the requirement. Just imagine the effect this would have on home values.
Although the price of Private Mortgage Insurance can vary based on your individual qualifications, the typical cost is roughly one percent of the mortgage amount per year, or $1,000 a year for every $100,000. So, for a
$300,000 loan, you can expect to pay about $3,000 a year in private mortgage insurance.
And here’s the silver lining. This is a small price to pay for otday’s historically low interest rates, especially when you consider the alternatives, namely waiting for the return of equity and/or saving for a heftier down payment. For many families, that could take a long time, and potentially put them at risk of higher future interest rates, which could end up costing them significantly more.