Your mortgage represents one of the largest financial commitments you’ll ever make. As housing prices in the United States continue to increase at a breakneck pace, it’s also a commitment that’s more difficult to make than ever. There is, as noted by CNBC, an acute shortage of affordable housing in the country.
What this means for prospective homeowners is that scrounging up a sufficient down payment is now more difficult than ever. It also means that Private Mortgage Insurance (PMI) may not be the exorbitant waste of money that many financial experts once believed it to be. Indeed, for many, it seems to be the only feasible route to homeownership.
That still doesn’t mean PMI is objectively a good idea, though. It still comes with a ton of drawbacks and a relatively narrow set of circumstances in which it’s justified. Today, we’re going to examine when you should consider PMI, and when it’s better to pursue an alternative.
What Is PMI, Exactly?
If a buyer is looking to register for a mortgage but cannot afford to make the minimum down payment (usually around 20 percent), many mortgage lenders will view them as a liability. They are, in the eyes of these organizations, far likelier to default on their mortgage than someone with larger, more stable financial reserves. PMI exists to protect them from this situation, providing them with a safety net that comes into effect in the event a homebuyer is unable to make a payment.
For homebuyers, registering for PMI allows them to receive mortgage financing with a down payment as small as three percent. However, as you might expect, there’s a catch. The cost of PMI is tacked on to the cost of your mortgage, with payments continuing until you’ve paid at least 20 percent of the property’s total value to your mortgage lender.
PMI is calculated based on several factors:
- Your credit score. As with your mortgage, better credit means more favorable terms.
- Your Loan-to-Value (LTV) Ratio. The larger your down payment, the lower your LTV. The lower your LTV, the lower your PMI payments.
- Your location. Different states have different PMI premiums.
- The number of mortgagees. The more people on your mortgage, the lower the risk. The lower the risk, the better your terms.
- Property details. This includes the type of property, the number of units, what you’re using the property for, whether it’s your first or second home, whether it’s a detached or attached property, and where it’s located.
- Type of mortgage. Fixed-rate mortgages generally offer more favorable PMI premiums than adjustable.
Arguments Against PMI
As noted by Investopedia, there are a number of reasons why PMI is a bad buy.
Purchasing PMI is a lot like purchasing a zero down payment smartphone or car. It only seems like it costs you less at first. In the long run, you could be spending as much as a thousand dollars a year on your insurance, possibly more depending on the terms you’ve negotiated.
It’s money that could easily be invested elsewhere, and it adds up. Particularly if your down payment was on the low side, you could be paying into your PMI plan for years. Worse still, that money is not tax-deductible.
It Doesn’t Actually Protect You
As we’ve already noted, PMI isn’t designed to protect the borrower in a mortgage. It’s meant to protect the lender. That means that if you want to actually protect your own investment, you’ll need to tack additional insurance payments onto what you’re already paying out.
The only thing PMI does is allow you to purchase a home slightly faster than might otherwise be possible. That’s it.
It’s Difficult To Cancel
When your home’s equity is above 20 percent, most PMI plans terminate. At least, that’s what they tell you. In reality, many PMI lenders have a convoluted cancellation process, one which requires a drafted letter and a formal appraisal of your home. And if the organization drags its feet on scheduling that appraisal, you’re still paying PMI in the interim.
Moreover, there are some PMI lenders that require a set time period for their contract. That means that in the event you come into a financial windfall that allows your home’s equity to go above 20 percent of what you owe, you can’t just back out of your contract. You still need to pay until it ends.
So When Should You Pay Out For PMI?
Even in light of the above, there are a few situations in which PMI is a justifiable expense. First, given that both home prices and interest rates are on the rise, it could actually end up saving you money. Let’s say, for example, you want to purchase a home that’s worth $200,000.
However, by the time you save up the proper down payment, the home’s value has spiked to $250,000. Not only do you still not have enough money, but your mortgage will end up costing you more as well. With PMI, you can avoid this situation.
This applies to your mortgage rate as well. Interest rates are going up alongside home costs. Consequently, waiting to purchase until you have a twenty percent down payment can lead to an interest rate that would see you making higher payments than you would with PMI.
Finally, it might be worthwhile to sign up for PMI even if you do have the money for a full down-payment. This will leave you with a financial cushion that you can either save for a rainy day or direct to another investment.
Alternatives to PMI
The main alternative to PMI aside from simply saving up the necessary money is to purchase what’s known as a piggyback mortgage. This incorporates multiple lenders, and can both net you more favorable terms and get you a mortgage with a smaller downpayment than would otherwise be possible. That’s really your only other option.