Private mortgage insurance,
more commonly known as PMI, is often misunderstood. Homeowners often believe that
it is a form of life insurance that pays off the mortgage if the borrower dies.
This is understandable since after all, the homeowner is paying for it. However,
it actually protects the lender against loan default and is normally required
for mortgages with less than a 20% down payment.
Generally,
homeowners who borrow 80% or less of the purchase price are less likely to foreclose
than those who borrow more than 80%. Therefore, in order for banks to take on
riskier loans and be willing to loan money to those with smaller down payments,
they usually require PMI. The mortgage market depends on mortgages being purchased
by third party investors such as the Federal National Mortgage Association (FNMA)
and the Federal Home Loan Mortgage Corporation (FHLMC). Selling the mortgages
provides banks with liquidity and allows them to loan out more money. The only
benefit that PMI offers to the borrower is the ability to purchase a house with
a smaller down payment.
The cost of
PMI is based on two factors: the borrower's credit rating and the loan-to-value
ratio. The loan-to-value ratio, or LTV, is the percentage of the purchase price
that is borrowed. We already know that PMI is usually required on loans exceeding
80% LTV. The higher the ratio is, the higher the PMI will be. Credit rating also
affects the cost. The lower the credit rating of the borrower, the higher the
PMI cost will be. For example, consider a homeowner with a good job, an excellent
credit rating, and who made a 5% down payment. He or she might pay 0.78% on the
loan value annually. However, someone with a poor credit rating who makes a 5%
down payment might have a PMI cost that exceeds 4% of the loan value each year.
PMI payment options include annual,
monthly, or single premium payment plans. Most often payments are made monthly
along with the mortgage payment. However, you can increase your mortgage interest
deduction on income taxes, if you pay for PMI in a single lump sum at closing
and add it to the loan amount. Otherwise, if paid monthly along with mortgage
payments, PMI is not income tax deductible on a personal home mortgage. Business
and rental property owners can deduct insurance costs allocable to the property
that may include PMI. It is tax deductible for rental or business property if
paid monthly.
PMI can be canceled once
the mortgage balance is less than 80% of the appraised value or the original purchase
price of the home. Thanks to the Homeowners Protection Act of 1998, canceling
PMI has become much easier. To do so, the homeowner must notify the lender that
the mortgage balance is now less than 80% of the original purchase price or submit
an appraisal showing that the mortgage balance is now less than 80% of the appraised
value. The homeowner is responsible for the cost of the appraisal.
The
Henssler Financial Group recommends that homeowners strive to make a down payment
of 20% to avoid the unnecessary cost of PMI.
