If your down payment on a home is less than 20 percent of the appraised value or sale price, you must obtain private mortgage insurance, known as PMI, with your lender. This will enable you to obtain a mortgage with a lower down payment because your lender is now protected against any default on the loan.
PMI charges vary depending on the size of the down payment and the loan, but they typically amount to about one-half of 1 percent of the loan, according to the Mortgage Bankers Association of America. Mortgage insurance premiums are not tax deductible.
PMI protects the lender in case you don't make your house payments. This doesn't mean you can blow off making your house payments -- if you fail to pay, the bank will still repossess your house.
The insurance company will pay the bank the difference between 20% and the amount you actually put down. If you put down 5% and default, the insurance company pays the bank the other 15% that you didn't pay.
Let's say you put down 10 percent or $10,000 on a $100,000 house. The lender multiplies the 90 percent loan, or $90,000, by .005. The result is an annual PMI of $450, which is divided into monthly payments of $37.50.
Most home buyers need PMI because 20 percent of the sale price on a home is a lot of money; for instance, that's $20,000 on a $100,000 home. Home buyers must maintain the PMI premiums until they cross that one-fifth-of-principal threshold, a process that can take years in longer-term mortgages.
Mortgage investors, such as the Fannie Mae and Freddie Mac programs, have recently come to the aid of the borrower by introducing an option to the primary mortgage market that allows borrowers to pay as little as 5% down and purchase only enough mortgage insurance to cover 25% of the loan; this creates a potential citing situation for the borrower.
In order to lower the cost of insurance that the advantage lays here, the borrower may pay a slightly higher interest rate: mortgage interest is fully tax deductible, PMI is not.
There's another option, also regulated by the federal government and passed into law in 1999, known as the homeowners protection act of 1998 established rules for regulation of PMI requirements once a homeowner reaches a level of 20% equity.
What the law requires, in layman's terms, is that a lending institution must notify you once your equity levels reach 20% of the appraised value of the home. Once you the kind of 20% equity level, you must be given the option to drop PMI.
If this proposal had passed into law some 20 years ago, it would have been met with great resistance among the lending community; today, the interest only loan and loans that offer mortgages in excess of the appraised value of the home overshadow the effect of the 1998 homeowner's act.
Remember, PMI is just to protect the lender for the amount that your down payment is below 20% of the house price. So you don't need it once you've made enough payments on your house that you own 20% of it.
Since many homeowners didn't know they could cancel, it used to be that the insurance company would keep happily charging you the premium forever. But starting in 1999 insurance companies are required to automatically cancel your PMI once you own at least 22% of your home, based on the original purchase price.
Given below are the different ways to avoid PMI.
When you don't have the standard 20 percent down payment, some new ways are there to avoid mortgage insurance in today's market.
Pay more interest
If the buyer accepts a higher interest rate on the mortgage loan, some lenders will waive the mortgage insurance requirement. Depending on the down payment, the rate increases generally range from .75 percent to 1 percent. The advantage is that mortgage interest is tax deductible.
"80-10-10" loan
This program involves two loans and a 10 percent down payment. The 90 percent loan is financed with a first mortgage equal to 80 percent of the sale price, and a second mortgage for the remaining 10 percent of the sale price.
The second mortgage has a higher interest rate but since it applies to only 10 percent of the total loan, the monthly payments on the two mortgages are still lower than paying one mortgage with mortgage insurance. Plus, again, there is the advantage of mortgage interest being tax deductible.
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