PMI is designed to protect the lender if the homeowner defaults on the loan. It does not protect the homeowner from foreclosure, but it allows prospective homebuyers to become homeowners even if they can’t afford a 20 percent down payment. PMI is arranged by the lender and provided by private insurance companies. This discussion on PMI relates to conventional1 mortgages only, as FHA mortgages do have PMI but have different rules pertaining to removing PMI2.
PMI is paid monthly with the mortgage payment, and the amount is calculated using a factor expressed as a percentage. That factor is then multiplied by the loan amount, divided by 12, thus determining the monthly PMI premium a borrower pays. The factor used is a function of the credit score3 and the loan- to-value (LTV). LTV is defined as the percentage of total purchase price (value) that is represented by the loan amount. A $90,000 loan on a $100,000 purchase price would be 90% LTV4.
The higher the credit score and the lower the LTV, the lower the PMI factor. For example, a borrower with a 740-credit score obtains a $500,000 loan, putting 10% down. Based on the credit score and LTV, the PMI factor is .26%.The monthly PMI premium is $108.33 (500,000 x .26% / 12). Another borrower with a 680-credit score obtains a $500,000 loan with 5% down. Based on the credit score and LTV, the PMI factor is .69%. The monthly PMI premium is $287.50 (500,000 x .69% / 12).
Every fully amortized mortgage payment is comprised of principal and interest. The farther into the term of the loan, the greater amount of the payment is allocated to principal. The loan balance continues to decrease over time due to the principal portion of the payments, and the rate at which the balance decreases also accelerates. This natural amortization reduction combined with possible appreciation due to market conditions or improvements to the property results in a continual decrease of the loan to value.
As this decrease occurs, opportunities may exist to reduce the PMI factors by virtue of a refinance.Note that PMI factors reduce with every 5% of LTV decreases. For example, the PMI factor on an 85% LTV loan is less than on a 90% LTV loan, which is less than on a 95% LTV loan, assuming the same credit scores in each case.
PMI can be eliminated without refinancing. The loan servicer must terminate the PMI automatically at the point where the natural amortization loan balance reductions reach 78% of the original purchase price. The length of time to reach this threshold is a function of the interest rate on the loan, the amortization period, and the original LTV.
If a homeowner would like to remove PMI before that natural balance reduction reaches the necessary loan amount, they can make that request either verbally or in writing. It is the homeowner’s responsibility to initiate that request. If the current market value has increased due to either improvements and/or market appreciation, a current market valuation can be requested. If the mortgage is between 2 and 5 years old, the current market LTV must be 75% or less. If the current mortgage is greater than 5 years old, the current LTV needs to be 80% or less to remove PMI. If FNMA’s minimum two-year seasoning requirement is waived because the property improvements made by the borrower increased the property value, the LTV ratio much be 80% or less. Note that in any case of removing PMI, it is required that the homeowner to be current on their mortgage, with no delinquent payments in the past 12 months, and no payment 60 or more days past due in the last 24 months.
Certain lenders offer loans with LTV’s greater than 80% without PMI. These are far less common but do exist. In these cases, the PMI is basically included in the interest rate on the mortgage. While the tax deductibility of PMI premiums is transitory in the tax code (in certain years the provision allows the premiums to be deducted, and then at times that provision gets removed from the code), this option may be beneficial from a tax perspective. In cases where PMI premiums are not tax deductible, it may be advantageous taxwise to obtain a loan with the PMI built into the rate, depending on how big a premium seems to be included in that interest rate. The downside to this approach would be that the option to remove PMI would not exist. If rapid appreciation or property value enhancements were to take place, the option of eliminating PMI without refinancing would not exist, costing a homebuyer more in the long run.
While PMI can add to the expense of obtaining a mortgage, it does allow borrowers the opportunity to own a home without having to produce a full 20% for a down payment. As real estate appreciation continues, homeowners can reap the benefits of homeownership and gain equity. Actively managing the mortgage, especially a mortgage with PMI becomes an essential element to homeownership. At Watermark Capital, our seasoned professionals can assist in monitoring current market conditions as far as interest rates are concerned and give valuable feedback on current market conditions for market value of the property, and the implications on PMI through a refinance. Minimizing the overall amount a homeowner must pay in PMI is an important component in home ownership.
1 See Conventional Loans, What is Fannie Mae and Freddie Mac?
2 See FHA Loan Basics.
3 See Credit: Scores and More.
4 See Mortgage 101.
