What is private mortgage insurance (PMI)?
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UPDATED: Feb 13, 2012
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Private mortgage insurance (PMI) is a type of security that is meant to protect a mortgage company from a defaulting borrower. In the event a borrower stops paying his monthly mortgage bill, the PMI will cover the lender by paying out a premium on behalf of the insured borrower.
But unlike insurance for automobiles, not everybody needs to take out PMI. Rather, the requirement for mortgage insurance is saved for borrowers who fail to put at least 20 percent down when acquiring their home loan. For those who don’t have 20 percent, or for those who like to forego the down payment, opting for PMI will still allow them to obtain a home ownership.
A Costly Decision
But the decision to willingly take out PMI is not one to be taken lightly because this type of security comes at a hefty price. The cost of PMI ranges, but is typically around 1 percent of the entire loan’s amount every single year. That means on a $200,000 home mortgage loan, a borrower can expect to pay out an additional $2,000 a year on PMI.
That $2,000 goes straight to the insurance company and does nothing for the balance of the home loan. Assuming this is a 30-year fixed rate mortgage, the borrower would pay out $60,000 in insurance payments over the loan’s lifetime.
Now consider a borrower who saved for a 20 percent down payment on this $200,000 home loan. He or she would put down $40,000, but be exempt from the PMI requirement. What may look like a $20,000 savings is actually a full $60,000 savings, since the down payment goes towards the balance of the home loan, whereas the $60,000 spent on PMI does not go towards the balance of the mortgage at all.
How to Avoid PMI
While 20 percent down can often take a long time to save up, it may be prudent for a prospective property buyer to wait it out. Or, if the bank of mom and dad is open for business, approach them for a little bit of help.
If that option isn’t available, a piggy-back arrangement may be considered. Piggy-backing refers to the practice of taking out multiple mortgage loans in order to satisfy the cost of one property. A borrower would enter what is known as an “80/10/10” agreement, wherein a first loan is taken out for 80 percent of the property’s value, a second “piggy-back” loan is taken out for 10 percent, and the remaining 10 percent is satisfied in the form of a cash down payment. Combining the 10 percent down payment with the money derived from the piggy-back loan allows the borrower to hit the required 20 percent down payment, and subsequently avoid the necessity for PMI.