Buying a Home | Financing | LendingTree
Private Mortgage Insurance – the Basics
By Craig Grella
Lenders use private mortgage insurance, known simply as PMI, to insure their loans against potential default. PMI also adds another layer of security on top of the normal underwriting procedures banks use to qualify their borrowers.
One of the main guidelines lenders use to qualify borrowers for a home loan is to analyze the loan to value ratio, also known as LTV. This ratio relates the loan amount to the market value of the home. A LTV of 80 percent means the loan being made represents 80 percent of the value of the home. For example, a home worth $250,000 that has a loan of $200,000 on is said to have an 80 percent LTV ($200,000 / $250,000 = 0.80 = 80 percent). Buyer’s obtaining a loan of 80 percent of the home’s price would have to use a 20 percent cash down payment to complete the purchase. The down payment would become the borrower’s equity position, which is equal to the value of the home minus any outstanding loans on it.
Traditionally, lenders would not extend loans on properties over 80 percent LTV because they were known to have a higher level of default than those under 80 percent LTV. The position is simple to understand, really: the more equity you have in your home, the less likely you are to walk away from it if things go bad. However, as the growth in home prices began to out pace the growth of income levels, many buyers could not afford a 20 percent down payment and more and more lenders began to adjust their underwriting methods to allow loans above the 80 percent LTV mark.
The cost of PMI
Today, the cost of PMI is generally .5 or .6 of the loan amount. This can be paid in two ways. You can include the PMI premiums as part of your monthly mortgage payment, or you may be able to roll the PMI into the loan, which would increase the interest rate on the loan and thereby increase increase your payment.
Other Considerations
Generally speaking, PMI is no longer required when your loan is paid down to the point the property is at 80 percent LTV or lower. At that point, a homeowner can apply to their lender to drop the PMI coverage and stop making the additional PMI payments. What’s more, according to the Homeowners Protection Act of 1998, PMI must be terminated automatically once you reach 22% equity in your home.
