Friday, August 2, 2013

What Is Private Mortgage Insurance (PMI) and How Does It Work?

Buyers who obtain conventional mortgage loans with less than a 20 percent down payment are required to buy private mortgage insurance, usually just called PMI. A conventional loan is one not insured by the Federal Housing Administration (FHA) or the Veterans Administration (VA). The monthly PMI premium is included in the borrower's monthly payment.

Many people think the private mortgage insurance policy pays off the loan in the event of default. It does not. If the borrower defaults, the policy pays an amount equal to what 20 percent down would have been, less the borrower's actual down payment. On a $300,000 home, for example, 20 percent would be $60,000. However, the buyer only put down 3.5%, or $10,500. PMI would therefore insure $49,500.

PMI matters in a couple of ways. First, as borrowers pay down the loan, their equity gets closer and closer to 20%. An increase in the market value of the home also may add to equity. Lenders, by and large (there are always exceptions), will drop the PMI requirement when the home hits 22% equity, based on the original appraisal. A borrower can also request the requirement be dropped when equity reaches 20%.  A caveat here: Many lenders require riskier borrowers to continue paying PMI well after the 20% level is reached.

A second thing to be aware of is that the PMI insurer is a stakeholder in a short sale. While more brokers and short-sale negotiators are aware of this fact now than in past years, some still are not. Neither are many homeowners. But the insurer must be contacted along with the other lenders and has to be part of the short sale agreement and can really hold things up.

Both the FHA and VA require payment of mortgage insurance as well, but in their cases, the insurer is an arm of the federal government and therefore not "private." The same rules pretty much apply, though.

Is PMI a good thing? Yes, because it's a private market solution to managing risk on loans, making more money available to potential borrowers.

Potential buyers may also hear the term, "lender-paid mortgage insurance." Under this scenario, the lender pays the insurer and charges the borrower a higher interest rate.

Question or comment? Let me know!