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If you purchased a home with less than a 20% down payment, or you’re about to, you’re familiar with Private Mortgage Insurance (PMI). PMI is an ‘evil villain’ in the eyes of family and friends who’ll likely tell you to “avoid it at all costs.” But in reality, PMI is a good thing.
It’s a tool that lets you buy a home without saving for a down payment for years by offering an insurance policy to the lender in case you stop paying your mortgage. The borrower (homeowner) pays the monthly insurance premiums for the policy on the lenders’ behalf.
You see over many years, and tens of thousands of mortgages, the data shows a significant percentage of borrowers who default (stop paying) on their mortgage made less than a 20% downpayment. Before 1957, you had to have a 20% down payment to qualify for a mortgage. Now, over 60 years later, PMI is still a great way to buy a home with less than 20% down payment even though it’s changed over the years.
How To Pay (or Not Pay) for PMI
If you’re getting a conventional mortgage, you have options for how to pay the mortgage insurance premium. You can pay one lump sum along at closing, you can elect to make a monthly payment, the most common method, or you can do a combination of the two – a little up front and a reduced amount monthly.
Paying a higher interest rate on your loan and avoiding mortgage insurance premiums completely, known as Lender Paid Mortgage Insurance (LPMI), is another option many buyers are considering. Even though the hunt for the lowest interest rate is paramount to borrowers – this is one time it might not be in your best interest.
Borrowers who elect LPMI will pay approximately one-eighth to one-quarter percent higher interest rate, and the lender will pay the mortgage insurance premium. There are good tax advantages to this option we’ll talk about in a minute, but it means you won’t ever ‘get rid’ of the burden of PMI.
Another way to avoid paying PMI is to structure your mortgage into two loans. How does that work? Commonly known as Piggyback loans, they are typically the first mortgage of 75-80% loan-to-value plus a second mortgage for 10-15% loan-to-value, giving a combined loan-to-value of no higher than 90%.
The second mortgage is usually a Home Equity Line of Credit (HELOC) with a variable interest rate.
FHA loans are another way to buy a home with less than 20% down payment, requiring a minimum of 3.5% down. The structure of the mortgage insurance premiums is much different for these government loans compared to private mortgage insurance. With an FHA loan, the Upfront Mortgage Insurance Premium is 1.75% of your loan amount.
You can pay this amount at closing or have it added to your loan balance and financed. You’ll also pay a monthly premium which is calculated by using between .85% and 1.00% of your loan amount (depending on your down payment) and then spreading that over 12 monthly payments.
So, government mortgage insurance premiums are costly for home buyers, and that’s not the most unattractive feature. We’ll talk about this later when we explain how to get rid of mortgage insurance.
Does Mortgage Insurance have any Tax Benefits?
The ability to write off mortgage insurance premiums is at the mercy of Congress. Initially allowed as part of economic recovery measures taken after the recession, they have been set to expire annually but have renewed through 2017. No word yet on what will happen to deductibility in 2018 or beyond.
As they stand, if you itemize on your federal taxes and your adjusted gross income (AGI) is no more than $100,000 ($50,000 for married filing separately) then the mortgage insurance premiums are 100% deductible. Go above that annual income and the percentage of premiums you can deduct starts to drop until it’s eliminated at $109,000 AGI ($54,500 for married filing separately.)
The tax deduction is for federal income taxes only. You’ll need to confer with an accountant to see if your state offers any deductions.
For buyers that choose the LPMI model, tax deductibility is available regardless of your AGI. Calculating the savings by taking either route should be done with the assistance of an accountant, but for example, a $600,000 mortgage at 5% (30 year fixed rate) would have a monthly payment of $3221 and not additional mortgage insurance premium. Compare this to the same mortgage at 4.75% plus PMI: payment $3130 and $380/monthly PMI payment. The higher interest rate LPMI would save you $289/month in cash flow before tax benefits.
When + How To Get Rid of PMI
How you eliminate the mortgage insurance requirement is different for private mortgage insurance than an FHA loan. For FHA loans originated after July 3, 2013, mortgage insurance ends after 11 years of payments if your loan was initially 90% loan to value (you put 10% down) and your loan term was longer than 15 years.
If you put less than 10% down, the mortgage insurance lasts for what’s called “the life of the loan.” In this case, you can sell your home to pay off the mortgage, and ultimately end the mortgage insurance, or you can refinance your mortgage into a non-FHA loan.
For conventional mortgages with private mortgage insurance, you have some options. For conforming loan amounts you can request that your lender remove the requirement for PMI after a minimum of two years has passed and you have 20% equity. This can be through a combination of your regular monthly payments and appreciation.
Lenders are required to automatically remove the PMI requirement when there is at least 22% equity in the property, via regularly scheduled amortizing payments. To prove the property has the adequate equity, before the regular amortizing payments reducing the loan amount, you will need to contact the loan servicer and pay for an appraisal to confirm the equity is adequate to allow for removing the requirement.