Homebuyers Grapple With Surprising Cost of Private Mortgage Insurance
According to Freddie Mac, the interest rates on 30-year fixed-rate mortgages averaged 6.95% in mid-December — double the rate paid by homeowners just two years ago.
Although Freddie Mac projects the housing market will improve in 2024, many homebuyers will still face an additional expense: private mortgage insurance (PMI).
PMI is a cost of homeownership that surprises many first-time homebuyers. It’s easy to overlook this charge in the excitement of going through the home-buying process, but paying PMI can be a real budget-buster for the unprepared homebuyer. It can add thousands of dollars in additional expenses every year.
Fortunately, with some planning and knowledge, it’s possible to avoid paying PMI.
What Is PMI?
Private mortgage insurance protects the lender if the borrower defaults on the mortgage. If the borrower cannot put a minimum 20% down payment on a conventional home loan, the lender will likely require them to pay PMI.
The advantage of PMI is that it allows homebuyers to purchase a home without making a complete 20% down payment. This might seem like a huge plus, since it saves the homebuyer from having to fork out a lot of cash upfront and still allows them to buy a home. But if the homebuyer does their research before purchasing, they might find the actual cost of PMI far outweighs its benefits.
How Much Could PMI Cost Me Each Year?
To clarify further, PMI is insurance that the homeowner pays to protect the lender, not the homeowner. PMI does not swoop in and make payments if the borrower fails to make mortgage payments.
Instead, PMI protects the lender if the homeowner defaults on the loan and the house goes into foreclosure. The thinking behind PMI is that if the lender needs to sell the foreclosed home at auction to recoup its money, it will recover, on average, about 80% of the home value, according to foreclosure statistics. The other 20% will be covered through the PMI policy.
PMI premiums can be hefty, generally ranging from 0.55% to 2.25% of the original loan amount. How much the borrower pays depends on factors like down payment amount and credit score. For example, if the PMI is 2% and the loan amount is $250,000, the borrower will pay $5,000 a year. In this scenario, most people pay PMI in monthly installments, which means they’ll pay about $416 a month. This payment is on top of their mortgage payments, property taxes, homeowner’s insurance, and home maintenance costs. Remember, this is not a one-time expense but a fee they’ll pay as long as the equity they have in their home is below 20%.
Five Ways To Save Money and Avoid Paying PMI
Given how costly PMI can be, it’s no wonder many homebuyers are eager to avoid the expense.
Shop Around for a Loan That Doesn’t Require PMI
Look for alternative loan programs that either waive the PMI requirement or provide down payment assistance. VA loans don’t require PMI, potentially saving the borrower a bundle if they qualify. Explore loans insured by the Federal Housing Administration (FHA) or the U.S. Department of Agriculture (USDA), as both agencies have programs to make homeownership more affordable for low- and moderate-income buyers.
Check Out State and Local Homebuyer Assistance Programs
More communities are prioritizing affordable housing, including developing new programs to assist home buyers. Some communities focus on “workforce housing,” which targets making homeownership affordable for people with certain occupations, such as school teachers, firefighters, or first responders. Borrowers can get started by checking out HUD’s local homebuying page for programs in their state.
Look for an 80-10-10 Loan
One strategy to avoid PMI involves getting an 80/10/10 loan where the borrower puts 10% down and takes out a 10% home equity line of credit and uses that to satisfy the 20% down payment requirement. Eric Simonson, founder of Abundo Wealth says the line of credit will likely be variable, so borrowers will want to prioritize paying that off sooner. If borrowers are unsure how to find a lender that offers 80/10/10 loans, they can check with their accountant or a local financial advisor, who can likely provide recommendations.
Pay a Higher Interest Rate
Some lenders offer loans that allow borrowers to avoid paying PMI in exchange for a higher interest rate. Borrowers will need to undergo a qualification process, but they’ll be allowed to put down less than 20% if approved. However, their monthly mortgage payment will be higher — in some cases substantially so — because they’ll be charged a higher interest rate.
Buy a Less Expensive Home
Just because a borrower is pre-approved by a lender for a certain amount doesn’t mean they need to max out that amount when they purchase their home.
“I generally don’t recommend using PMI to buy a bigger home that stretches your finances, since any hiccup in your life could make your mortgage harder to pay and introduce a lot of stress,” says Stanley Himeno-Okamoto, founder of DRS Financial Partners.
A wiser approach for a first-time homebuyer might be to buy a “starter home” — a less expensive one that they can comfortably afford without having to incur PMI.
Perhaps the most obvious solution to the PMI dilemma is for the borrower to reconsider buying a home until they can put 20% down, thereby avoiding PMI entirely. While this might delay their homeownership dreams for some time, it might also provide an opportunity to take a step back and consider is the best time for them to take on the responsibility and expense of homeownership.
Waiting until they’ve saved enough money to buy a home with 20% down will put them in a stronger financial position to negotiate better terms with lenders. It will also allow them to carefully weigh all their options before making what will probably be one of the most important purchases of their life.
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