July 30, 2020

What is PMI?

PMI stands for Private Mortgage Insurance. This is an added cost for home buyers that is different from home insurance. It protects lenders in case borrowers default on their loans. Borrowers whose down payment does not meet a set minimum (usually 20% of the purchase price) must pay for PMI every month on certain mortgages.

How Much Does PMI Usually Cost?

The cost of PMI can vary, but it is a borrower-paid cost which can run from around $40 to $200 each month.

The good news is that once you have paid off a minimum amount of the mortgage (usually 20%), you will no longer need to pay for PMI.

Should I Avoid Paying PMI?

That magic number: 20%—the down payment we should all strive for—right? Not necessarily.

For the average American home, 20% amounts to a pretty big number. Throw in closing costs, and you’ve got a small fortune to raise.

It’s certainly a good idea to put money away toward what will likely be the largest purchase of your life, but in reality, the amount you put down should be based on your full financial picture. It’s true that a higher down payment means you’ll have a smaller monthly mortgage payment, but there are more aspects to consider.

Instead of waiting and saving for years, a buyer could put down less than 20% and start building equity sooner. While this is different from a traditional investment, it’s not a bad idea to consider that the cost of PMI today may put you ahead in the long run.

There are also some options out there for first time home buyers who want to avoid paying PMI but can’t put more than 20% down right now.

Other reasons you might put less than 20% down:

  • Conserve cash: You’ll have more money available to invest and save, and more money for furniture, emergencies, or other issues.
  • Pay off debt: Many lenders recommend using available cash to pay down credit card debt before purchasing a home. Credit card debt usually has a higher interest rate than mortgage debt – and it won’t net you a tax deduction.
  • Improve your credit score: Once you’ve paid off debt, expect to see your score spike. You’ll land a better mortgage rate this way, especially if your score tops 730.
  • Remodel: Few homes are in perfect condition as offered. You’ll likely want to make some changes to your new home before you move in. Having some cash on hand will allow you to do that.
  • Build an emergency fund: As a homeowner, having a well-stocked emergency fund is crucial. From here on, you’ll be the one paying to fix any plumbing issues or leaky roofs.
  • Taking advantage of low mortgage rates: If rates have dipped low and are expected to rise again later, waiting to save up 20% might cost you in interest.

Drawbacks of smaller down payments:

In all fairness, there are some drawbacks of making a smaller down payment.

  • Mortgage insurance: A PMI payment is an extra monthly expense piled on top of your mortgage and property tax. As mentioned above, though, PMI can be a good investment.
  • Potentially higher mortgage rates: If you’re taking out a conventional loan and making a smaller down payment, you can expect to have a higher mortgage rate. However, if you’re taking out a government-backed loan, you’re guaranteed a lower mortgage rate despite a less-than-robust down payment.
  • Less equity: You’ll have less equity in your home with a smaller down payment. Of course, unless you’re planning to sell in the next few years, this shouldn’t have any tangible effect on your homeownership.

Of course this doesn’t mean you should buy a home no matter how much–or how little–you’ve got in your savings account. Before making this decision, be sure you can really afford to own a home.

Options for Saving

Whether you decide to save up 20% or less than 20% of your home purchase price, you have options on how to store (and possibly grow) your deposits. Here are some of the most popular and simple ways to save:

Checking or Savings Accounts

These generally produce a small return, but at least it’s something. They are, however, very convenient, if you are disciplined about not spending the money that’s earmarked for your down payment. If your savings is very small, it may make sense to keep it here instead of paying fees to maintain a low balance account.

These are guaranteed against bank failures up to $250,000 per account holder, either from the FDIC (Federal Deposit Insurance Corporation) for banks or the NCUA (National Credit Union Association) for credit unions.

CD (Certificates of Deposit or Share Certificates)

These typically pay a higher yield than checking or savings accounts, and also qualify for federal insurance coverage. However, they do require you to commit your money for a specific period of time. The penalty for early withdrawals is usually the equivalent of six months of interest.

Money Market Accounts

This is a type of mutual fund that’s made up of low-risk, short-term bonds and commercial paper designed to maintain a stable per-share price of $1 per day.

By and large, they have been able to do so, historically, though there are no guarantees. They may offer higher yields than guaranteed accounts, and do not require a time commitment. However, there is a possibility that your money market will lose money.

When can I stop paying for PMI?

The 20% rule is helpful here. Once you’ve paid down enough of the loan to have 20% equity in your home (meaning your loan amount is less than 80% of the home’s market value), most lenders will no longer require PMI.

Even with a 20% stake in your house, you may have to pay for PMI a little longer. Policies are generally purchased for a year, and monthly payments are held in escrow to cover yearly premiums. You may have to continue paying the premium until the year in which you reach 20% equity ends.

Also, if you happen to live in an area where home values have risen, investigate the ability to get a new appraisal if you are paying PMI. If your home has gone up in value enough to get you past that 20% threshold, you may be able to request cancellation of the PMI on your loan.

This article is for educational purposes only. Tulsa FCU makes no representations as to the accuracy, completeness, or specific suitability of any information presented. Information provided should not be relied on or interpreted as legal, tax or financial advice.