There’s a cost of homeownership that surprises many first-time homebuyers, one that’s easy to overlook in the excitement of going through the homebuying process. It’s called private mortgage insurance or PMI. For the unprepared homebuyer, the cost of paying PMI can be a real budget buster, adding thousands of dollars in additional expense each and every year. Fortunately, with a little advance planning and knowledge, there are five ways you can avoid paying PMI.
What is private mortgage insurance (PMI)?
The purpose of private mortgage insurance is to protect the lender in the event you default on your mortgage. If you’re unable to put a minimum 20% down payment on a conventional home loan, your lender will likely require you to pay PMI.
The advantage of PMI for homebuyers is that it allows them to buy a home without having to pay a full 20% down payment. On the face of it, this might seem like a huge plus, saving the homebuyer from having to fork out tens of thousands of dollars upfront and still enabling them to buy a home. But if you do your research before you buy your home, you might find the true cost of PMI far outweighs its benefits.
How much could PMI cost me each year?
Again, it’s important to emphasize that PMI is an insurance that the homeowner pays that protects the lender not the homeowner. Should you fail to make your mortgage payments, PMI does not swoop in and make your payments for you.
Instead, PMI provides the lender with some protection in the event the homeowner defaults on the loan and the house goes into foreclosure. The thinking behind PMI is that if the lender needs to sell the foreclosed home at auction to recoup its money, it will (according to foreclosure statistics) recover on average about 80% of the home value and the other 20% will be covered through the PMI policy.
PMI premiums can be hefty, generally ranging from 0.55% to 2.25% of your original loan amount. How much you’ll actually pay depends on factors like your down payment amount and your credit score.
For example, if your PMI is 2% and your loan amount is $250,000, you’ll pay $5,000 a year. Most people opt to pay PMI in monthly installments, which means you’ll pay about $416 a month in this scenario. This is on top of your mortgage payments, property taxes, homeowner’s insurance, and home maintenance costs.
Keep in mind this is not a one-time expense, but an expense that you’ll need to pay as long as the equity you have in your home is below 20%.
5 ways to save money and avoid paying PMI
Given how costly PMI can be, it’s no wonder many homebuyers are eager to avoid the expense. Here are some ways you can avoid paying PMI.
- Shop around for a loan that doesn’t require PMI. Look for alternative loan programs that either waive the PMI requirement and/or give you down payment assistance. For example, VA loans don’t require PMI, so if you qualify you could save a bundle. Look into loans insured by the Federal Housing Administration (FHA) or the U.S. Department of Agriculture (USDA). Both agencies have programs aimed at making homeownership more affordable for low- and moderate-income buyers.
- Check out state and local homebuyer assistance programs. More communities are making affordable housing a priority, and this includes developing new programs aimed at assisting homebuyers. Some communities focus on what’s called “workforce housing,” which targets making homeownership affordable for people with certain occupations, such as school teachers, firefighters, or first responders. You can get started by checking out HUD’s local homebuying page for programs in your state.
- Look for an 80-10-10 loan. These are sometimes called “piggyback loans” and they are structured to help you avoid PMI. They combine your 10% down payment with two loans—the first loan covers 80% of the home’s purchase price and the second loan covers the additional 10% down payment.
- Pay a higher interest rate. Some lenders offer loans that allow you to avoid paying PMI in exchange for a higher interest rate. You’ll need to go through a qualification process, but if approved, you’ll be allowed to put down less than 20%. But your monthly mortgage payment will be higher—in some cases substantially so—because you’ll be charged a higher interest rate.
- Buy a less expensive home. Just because you’re pre-approved by a lender for a certain amount doesn’t mean you need to max out that amount when you purchase your home. A savvier approach for a first-time homebuyer might be to buy a “starter home,” a less expensive one that they can comfortably afford without having to incur PMI.
A Final Thought…
Perhaps the most obvious solution to the PMI dilemma is to reconsider buying a home until you’re able to put 20% down, thereby avoiding PMI entirely. While this might delay your homeownership dreams for some time, it might also provide you with an opportunity to take a step back and consider if now is really the best time for you to take on the responsibility and expense of homeownership. Waiting until you’ve saved 20% will put you in a stronger financial position to negotiate better terms with lenders. It will also give you an opportunity to carefully weigh all your options before making what will probably be one of the most important purchases of your life.