Private Mortgage Insurance

Definition

Private mortgage insurance (PMI) is a type of insurance that protects lenders against the risk of default by borrowers who are unable to make their mortgage payments. It is typically required when a borrower makes a down payment of less than 20% of the home's purchase price, making it an important aspect of certain real estate loans and mortgages that allow for lower down payments while safeguarding the lender's investment.

5 Must Know Facts For Your Next Test

1. PMI can be canceled once the borrower reaches 20% equity in their home, allowing them to save on monthly mortgage costs.
2. The cost of PMI varies based on the size of the down payment and the loan amount, typically ranging from 0.3% to 1.5% of the original loan amount per year.
3. Borrowers can pay PMI as a monthly premium, as a one-time upfront fee at closing, or through a combination of both.
4. PMI does not protect the borrower; it is solely for the lender's benefit in case of borrower default.
5. Certain government-backed loans, like FHA loans, have their own mortgage insurance requirements that differ from traditional PMI.

Review Questions

• How does private mortgage insurance impact borrowers who make low down payments?
  • Private mortgage insurance allows borrowers who can only make a low down payment, usually less than 20%, to secure a mortgage loan. While this enables more individuals to enter homeownership, it comes with an additional cost in the form of PMI premiums. This can increase monthly mortgage payments and overall loan costs until they build enough equity in the home to cancel PMI.
• Discuss how the loan-to-value ratio influences the need for private mortgage insurance in real estate transactions.
  • The loan-to-value ratio (LTV) is crucial because it measures the amount of the loan against the appraised value of the property. If the LTV exceeds 80%, lenders often require PMI to mitigate their risk since this indicates a smaller down payment and higher potential for borrower default. Thus, LTV is directly linked to whether or not borrowers will need to pay PMI when obtaining financing.
• Evaluate the long-term financial implications for homeowners who pay private mortgage insurance compared to those who do not.
  • Homeowners who pay private mortgage insurance may face higher initial monthly costs due to added PMI premiums, which can strain budgets especially for first-time buyers. However, by allowing these buyers to purchase homes sooner with smaller down payments, PMI can facilitate wealth-building through home equity over time. In contrast, homeowners who make larger down payments avoid PMI and save on those extra costs but may delay homeownership while saving up for larger upfront payments.

Related terms

Down Payment:

The upfront payment made by a buyer when purchasing a home, usually expressed as a percentage of the purchase price.

Loan-to-Value Ratio (LTV): A financial term used by lenders to express the ratio of a loan to the value of an asset purchased, often influencing the requirement for PMI.

Mortgage Insurance Premium (MIP): A type of insurance premium paid by borrowers with Federal Housing Administration (FHA) loans, serving a similar purpose to PMI.