If you're looking to be one of the 52 percent of home buyers that make their first-ever home purchase in 2017, I feel like I could probably sum up your thoughts as this: "How the hell are we gonna make it happen?" I know this because I was in your shoes this time last year—wanting desperately to buy a place of my own but, after earnestly crunching the numbers, feeling more discouraged than ever.
But we did it. We made homeownership happen. And what made it possible for us was Private Mortgage Insurance, or PMI.
What is PMI?
Private mortgage insurance is exactly that, insurance. It's not so different than the premium you pay to your car or renter's insurance company to protect your stuff in case of emergency, only in this case, you're paying it in order to protect your lender.
When you take out a mortgage and close on a home, you only really own as much of the house as you've paid for in cash, whether that's 2 percent or 20 percent. The "bank," i.e. your lender, owns the rest (they did technically front the rest of the money for you). When you put only 10 percent down, for instance, the bank is taking a sizeable risk on your behalf, buying 90 percent of your home and hoping that you made a solid investment and will keep paying your debts. In that case—when you're making a down payment of less than 20 percent of your home's purchase price—your lender will take out a private mortgage insurance policy, typically folding the policy premium into the mortgage payment you make to the lender each month.
If for some reason down the line, you can't keep up your payments and have to default on your loan, your lender can activate the mortgage insurance policy to protect their end of the investment.
It's important to realize that private mortgage insurance doesn't directly benefit you as the buyer—if you default on your loan, you'll certainly still be in hot water.
Why Would You Want PMI?
In my case, waiting to buy a house until my husband and I had 20 percent down would have made buying a home impossible. The location and size of home we had our eye on here in Atlanta would cost at least $250,000—making a 20 percent down payment at least $50,000. Like many millennials, we don't have that type of cash lying around (not to mention the extra 5 percent we'd need for closing costs). Although we're responsible with money, that type of savings was going to be a long way off for us. Instead, we were able to put just 5 percent down and buy a home right now.
My husband and I are not alone in opting to pay PMI to make homeownership more accessible. According to the Realtors Confidence Index, 62 percent of all home buyers in 2016 made a down payment smaller than 20 percent of their home's purchase price. And among just first-time buyers? A big chunk of them (66 percent) made down payments between only zero and 6 percent.
How Does PMI Work?
It's a premium you pay to your lender. For most buyers, it's an additional expense tacked on to your monthly mortgage payment (although that depends on your lender). Your specific private mortgage insurance premium will vary depending on the cost of your home and your credit score, but you can estimate the total to be between 0.3 percent and 1.5 percent, annually, of the original loan amount. On a $200,000 home with 10 percent down, your loan will be $180,000 and your mortgage insurance could cost $1,800 per year (at 1 percent), or $150 per month—on top of your mortgage payment, property taxes and homeowner's insurance.
When you've built enough equity in your home that your loan-to-value ratio is 80 percent or lower, you can request to cancel your PMI (your lender is required to cancel it for you once your LTV reaches 78 percent). Or in other words, once you have paid enough that you own 20 percent of your home's original purchase price, you're off the hook with the insurance premiums. But be warned that it can take a long time to get there. The less you put down as a down payment initially, the farther you have to go in mortgage payments to add up to 20 percent of your home's worth (especially since your first several years' worth of mortgage payments are mostly paying interest and not adding to your equity very much). To give you a very general idea, in my case, we'll have 20 percent equity in our home after around eight years of owning it and making mortgage payments.
What About Mortgage Insurance on FHA Loans?
Currently, FHA loans (or Federal Housing Administration loans) are mortgage loans insured by the United States federal government. You might take out an FHA loan if you have less than 5 percent to put down on your home (FHA loans require at least 3.5 percent), or you have a low credit score that prevents you from taking out a conventional loan.
FHA loans are subject to a different sort of insurance called simply a Mortgage Insurance Premium, or MIP. Unlike with the PMI on conventional loans, FHA mortgage insurance premiums, in most cases, cannot be canceled, and you'll be paying the insurance premiums for the entire length of the loan, regardless of the equity you've built up.