If you're entering the home buying process, the term PMI will probably pop up on your radar. So what is PMI, and what does it have to do with your bottom line?
Private Mortgage Insurance, or PMI, is required on most mortgages with a loan-to-value ratio of 80% or more. In other words, if you put less than 20% down when buying a home, you will probably have to pay PMI.
A third-party insurer provides PMI to protect the mortgage lender. This is a critical point. Many homebuyers think PMI is designed to somehow protect them, but this is not the case. PMI protects the lender in case you default on your loan.
The only way PMI benefits a buyer is by helping them qualify for a loan in the first place. Beyond that, PMI does nothing for the homebuyer is merely one more thing to pay each month (normally half a percent of the loan amount).
This is not to say that PMI is all bad. It helps people with bad credit (or those who can't afford a 20% down payment) obtain a loan they wouldn't otherwise be able to obtain. So for some, PMI is the only path to homeownership. But for others, PMI is more avoidable.
Even if you can't afford a 20% down payment, there are ways to avoid paying PMI:
PMI Sidestep #1
You can get an 80-10-10 loan. In this option, you would pay 10% down and then obtain two loans for the remaining 90%. And because no single loan accounts for more than 80% of the home's value, you would avoid having to pay PMI. Interest on the second loan (the loan for 10%) will be higher, but the two loan payments combined will still probably be lower than a single loan with PMI on top.
PMI Sidestep #2
Another way to avoid PMI (while putting less than 20% down) is to pay a higher interest rate.
Here's the key to the two approaches above. Mortgage interest is tax deductible -- PMI is not. In the options above,you could conceivably pay less each month and have more to write off at tax time. With the PMI option, you might end up paying more each month with less of a write-off.
Bottom line: PMI can help some people qualify for a loan who might not qualify otherwise. But in most cases, PMI is best avoided if at all possible -- or discontinued as soon as you reach the 20% equity mark (80% loan-to-value or lower).
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