Private Mortgage Insurance.

Private Mortgage Insurance (PMI)

 is intended to make homeownership possible for people who want to buy a home but who can’t afford a 20% down payment. It is insurance required on loans that cover more than 80% of the home’s value, in order to protect the lender from possible default on the loan. A fee is charged by the insurance company for the mortgage insurance, which must be paid in addition to the principal and interest on a loan. Once the loan-to-value ratio of the property is below 80%, however, either through paying down the loan or through the appreciation of the property, PMI can be canceled.

In response to consumer demand for low down payment loans with as few fees as possible, lenders have begun to offer alternatives to PMI: two mortgages. This usually occurs in the combination of an 80% first mortgage, a 10% second mortgage, and a 10% down payment; but variations also occur, such as a 75% first, a 20% second, and 5% down.

Borrowers should discuss carefully with their lenders or brokers what the monthly and long-term costs are for PMI and non-PMI options. The smaller, second mortgages usually carry a shorter term (e.g., 15 years) and a higher interest rate than the first mortgage, and thus may increase the borrower’s monthly outlay. However, paying for PMI will also mean an increase in monthly payments.

You should keep in mind two considerations about PMI and second mortgages. First, PMI is a fee being charged on the entire amount of the home loan—which may, in the long run, be a larger dollar amount than the second mortgage amount. Second, interest paid on a second mortgage may be tax-deductible—PMI is not.

Let’s examine the costs of PMI. As an example, let’s say a borrower takes out a loan that is 90% of the value of the home, or 90% loan-to-value, and is charged 0.25% for PMI. For that extra 10% above the 80% PMI threshold, the borrower is paying an extra 0.25% on all 90%. In the final calculation, the extra 10% is costing the borrower a full 2.25% more over the life of the loan. A borrower who plans to own his or her home for a longer period of time (generally 5-7 years or more) may find paying a slightly higher percentage for a second mortgage more palatable than paying PMI.

A good counterexample is a borrower who may only plan to own his or her home for a very short term—perhaps only a year or two. Because the monthly payment for PMI is likely to be less than a payment on a second mortgage, the borrower will have more funds available on a monthly basis to pay for improvements or other investments. He or she will still have paid less over the year or two of ownership by paying PMI rather than paying a second mortgage.

There is no single answer to the PMI question. What this means is that you should work with your loan officer or broker to determine whether paying PMI will best suit your needs. You may not have much cash for a down payment, but can make a substantial monthly payment; you may feel that the property will appreciate rapidly, which might allow you to cancel PMI in a year or two; or you might plan to stay in the property for 15 years or more, in which case you may be looking for the lowest costs over the long term. Your loan officer will be able to help you evaluate which option will best suit your needs and your unique situation.