The down payment is a very important part of mortgage financing. It greatly influences the interest rate that applies to your loan. It may even determine if you get a home financing or not.
The size of your down payment also dictates whether or not you will have to pay for a private mortgage insurance (PMI). If you pay less than 20 percent of the home value as down payment, a lender may require you to get a private mortgage insurance.
What is a Private Mortgage Insurance (PMI)?
A PMI is a type of insurance that protects the lender in an event that a loan default. The insurance will cover the lender for any financial losses when the property reaches foreclosure. The borrower pays for the PMI. In short, it only benefits the lender.
Private mortgage insurance fees can be costly. It can amount to 0.3 to 1.5 percent of the monthly payments. The fees vary depending on many factors. These include the borrower’s credit score and the size of the down payment.
Bob buys a house and gets a mortgage of $200,000. If he puts a 20 percent down payment which is $40,000, the lender won’t require him to get a PMI. But if Bob can only afford $20,000 down payment which is just 10 percent of the home price. A PMI applies.
Let’s say that the private mortgage insurance rate for Bob is 1 percent or .01. The needs to pay an annual insurance premium of $2,000. To calculate the monthly payment amount, you divide the annual premium by 12 (months). The result is $166.66.
*Take note that the insurance rate varies depending on the size of the down payment, the credit score, and the insurer.
A private mortgage insurance allows you to get a mortgage even if you don’t have 20 percent home equity. However, you do not have to pay for it for the entirety of the mortgage loan term.
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The Law Says it Can be Removed
A PMI can be removed. Under the law, a mortgage lender must inform the borrower that a private mortgage insurance can be canceled and when this can be done. During the closing, your lender will discuss the PMI including how long it will take to pay sufficiently so you can have it removed. This is stated in the “PMI Cancellation Act” (The Homeowners Protection Act of 1998).
By law, the lender must automatically remove your private mortgage insurance once your loan-to-value ratio has dropped to 78 percent. However, if you want to get rid of it much sooner, you can request a PMI cancellation once you’ve reduced your loan-to-value ratio to 80 percent.
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PMIs are Different from FHA’s MIP
Don’t get it all mixed up. We are talking about PMI, not FHA Mortgage Insurance Premium (MIP).
FHA mortgage insurance premiums can’t be canceled. You will be paying the premium for the duration of the loan unless you refinance your mortgage.
If your home is FHA-insured and you’re paying a high premium, the only way you can get rid of it is when you refinance to a conventional loan. If the market rate for conventional loans fall, refinancing to remove the FHA MIP can be a smart move.