Loan-to-value (LTV) ratio
Loan-to-value (LTV) is what the lender looks at to determine if you have to pay PMI and when you can stop paying it. To calculate this ratio, take the loan amount and compare it to the current value of your home. For example, if your mortgage is $150,000 and your home is currently worth $200,000, your loan-to-value ratio is 75%.
When you buy a new home, your lender will compare your down payment amount to the sales price to determine the loan-to-value ratio. So if you buy a house for $200,000 and make a down payment of $20,000, your loan-to-value ratio is 90%. Typically, if your loan-to-value ratio is more excellent than 80%, you will be required to pay PMI.
What is private mortgage insurance?
When you apply for a mortgage, the lender wants to make sure your home has enough equity to pay off the loan balance if you default and go into foreclosure. But since foreclosed homes are often sold at a “discount,” lenders want a cushion of at least 20%. In other words, they want to be reasonably sure that they can get back the money they slow you down if the house has to sell for less than the original asking price.
However, this does not mean that lenders are unwilling to issue loans when you deposit less than 20%. They charge you more for the privilege through PMI. This way, you get a mortgage, and they minimize the risk of offering you a loan. Private mortgage insurance is an actual insurance policy issued by an insurance company that benefits your lender. Suppose your home goes into foreclosure and the lender cannot recover the outstanding balance by selling the house. In that case, the insurance company that issued your PMI will pay the lender the difference.
PMI is called “private” because it is only offered to private companies and not government agencies or public mortgage lenders. Public programs, such as the FHA and VA mortgage programs, have their mortgage insurance, but it is managed differently and managed internally. However, one notable difference between PMI and the mortgage insurance attached to many FHA and VA loans is that the latter never expires. In other words, you will continue to pay mortgage insurance on FHA and VA loans even after the loan-to-value ratio has dropped below 80%.
Who needs private mortgage insurance?
Generally, you are free if your LTV ratio is less than 80%. However, if you have poor credit or are considered high risk by the lender, you may need to carry PMI even if you have a 70%, 60%, or even 50% loan-to-value ratio.
You may be considered “high risk” if you have recently sold multiple homes, been foreclosed on, or have unstable or undocumented income. However, this should be clearly stated in your loan documents, and if you’re not sure how it works, get a clear answer from your loan officer before you sign.
How to avoid paying private mortgage insurance
The best way to avoid paying PMI is not to have it on loan, to begin with! If you’re buying a new home but won’t have a significant down payment, ask your loan officer for tips on avoiding PMI.
In the past, a popular option was the 80-10-10 or piggyback mortgage, which used a combination of a second mortgage or home equity loan and your down payment to reduce the ratio of the loan to the value of the primary mortgage. This may still be available through some lenders today.
But if you’re already on a mortgage that has PMI, you have two options to remove it:
Meet the loan-to-value ratio
If your loan is close to the 80% threshold or whatever threshold your lender has stipulated in the initial mortgage paperwork, the lender will automatically remove PMI. In practice, most lenders expect up to 78%, but they’ll remove it sooner if you call and ask.
Since your lender will calculate the LTV from the original purchase price, you’ll need to keep track of the current market value of your home. In other words, if your home has increased in value, you can get a professional appraisal and present it to the lender as proof that the matter has increased.
While professional appraisals typically cost a few hundred dollars, this can be money well spent if you’re left without paying PMI several months or years sooner than you otherwise would have.
Refinance the mortgage
Before you refinance a mortgage, compare the cost to the monthly savings. Also, be sure to compare apples to apples. In other words, if you have 25 years left on your current loan, request quotes from the lender for a 25-year mortgage on your current loan balance and see how the numbers add up.
If your current loan requires PMI and a new one doesn’t, and you also qualify for a lower interest rate, a refinance probably makes sense. For example, let’s say your current loan requires a 70% loan-to-value ratio before you can stop paying PMI, and your current loan-to-value ratio is 75%.
If your credit has improved since you applied for the original mortgage, you may be able to refinance into a new mortgage where the PMI threshold is 80%. This means that you would not have to pay PMI with the new mortgage.
But to determine if this refinance saves you money, look at how long it takes to recoup your closing costs through your monthly savings, and make sure you’re in the house that long. Again, and this can’t be overstated, be sure to compare apples to apples when reviewing lenders’ quotes: the new loan term and balance should be the same as your current mortgage.
Last conclusions
Paying for private mortgage insurance is often a necessary cost if you want to buy a home without a significant down payment. However, you should understand the terms of your current mortgage contract and calculate the loan-to-value ratio to avoid paying more than you have to.
Plus, knowing when and how to eliminate PMI will lower your monthly mortgage bill. Follow the tips above, and the next time you apply for a mortgage, make sure you understand the PMI rules and ask for clarification before you sign.
Do you pay for private mortgage insurance? What are some steps you are taking to remove it from your home loan?
