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What Is PMI?

For many home buyers, private mortgage insurance (PMI) has become a way of life. Traditionally, if a home is purchased with down payment less than 20 percent of the appraised value or the sale price, the buyer is required to purchase PMI. This insurance protects the lender against default on the loan. With home prices on the rise, most home buyers are unable to raise the cash for a 20 percent deposit, and should plan on purchasing PMI.

Don't confuse Private Mortgage Insurance with Mortgage Life Insurance, they are are totally different.

PMI adds to the buyer’s total monthly payment which already includes mortgage and property taxes. Generally PMI amounts to between one half to one percent annually of the total loan, and varies depending on the amount of the loan and the down payment. The annual PMI cost is then divided into 12 equal monthly payments.

It should be noted that the buyer is not required to continue to pay PMI costs for the entire duration of the mortgage. Once the loan to value rate reaches 80 percent, PMI can be discontinued by the buyer. The Homeowners Protection Act of 1998, which became effective in 1999 requires lenders to inform the buyer at closing exactly how many years it will take for the loan to reach the 80 percent ratio so that he or she can cancel the PMI. The law also states that lenders have to cancel the PMI themselves when the ratio reaches 78 percent. The only exception to this law involves “high risk” borrowers, including reduced documentation loans and those with poor credit histories or high debt to income ratios. In these cases, the lender may require PMI until the loan reaches a 50 percent ratio.

There are a few ways to avoid PMI, even without a 20 percent down payment. Lenders will sometimes waive the requirement for PMI if the buyer is willing to pay a higher interest rate on the loan, usually three quarters of a percent to one percent more than they would have with the PMI. It doesn’t seem like this would be much advantage to the buyer, who would still have a higher payment each month, but at least if the difference is going toward interest instead of insurance, it is tax deductible.

Another way some buyers avoid PMI is by obtaining an “80-10-10” loan. This means that the buyer is actually taking out two mortgages, one for 80 percent of the home value, and a second mortgage for 10 percent. The 10 percent down payment remains the same. While the second mortgage can be expected to have a higher interest rate, since it is on only 10 percent of the home’s value, the total payment for the buyer is still less than paying a single 90 percent loan with PMI.