Mortgage insurance, or private mortgage insurance (PMI) (also referred to as mortgage guaranty insurance), is required for certain types of loans and is a way of offsetting the risks of the lender. PMI protects the lenders against loss should a borrower default on their loan.
How Does PMI Help You?
When you are applying to obtain a mortgage with a PMI requirement, your lender will usually allow you to make a much smaller down payment. This can mean the difference between saving up 20% of the home loan to make the down payment with, or only saving up 10% to use for a down payment on a loan with PMI.
How PMI Works
If you were to stop making payments on your mortgage, your lender must foreclose on you and obtain the title to that mortgage property. This takes time and money. If the property cannot be sold for an amount that is equal to the amount of your loan, which is usually the case, the lender faces a loss. However, PMI can reduce or eliminate this risk. When a borrower with PMI defaults, the lender can submit a claim to the company that was providing the mortgage insurance. This claim will usually include the cost of the loan, attorney fees, interest, taxes, and other charges associated with foreclosure. This often equals an amount that is 105%-110% of the original loan amount.
Once this claim has been submitted, the insuring company will either pay the lender a certain amount to help make up for their loss, or take the title to the property. When this happens, the insuring company is assuming the risk associated with the sale of the property. This is most beneficial when there is a high loan to value ratio. Most lenders will require a borrower to pay PMI if the loan to value ratio is higher than 80%. The annual rate of your PMI will vary depending on the loan characteristics.
Owner-Occupied: ‘Owner-occupied’ means that the owner of the mortgage uses the property as their primary residence. Most home loans with PMI are owner-occupied houses. Mortgage companies usually have separate clauses and PMI rates for homes that are ‘non-owner-occupied’. This is because the risk for the lender is higher with secondary homes and properties.
Loan-To-Value-Ratio: The Loan-To-Value ratio (LTV) is a quantitative figure that shows how much your loan is worth compared to how much the property is valued at. It is derived by dividing the original loan amount by either the sales price or the property’s market value. For example, if you purchase a home for $450,000 and the home’s market value is appraised at $480,000, the LTV for that property is .9375, or 93.75%. Recall that mortgages with an LTV ratio over 80% usually come with a mortgage insurance requirement. The LTV is also used to determine which PMI rates should apply. The lower the LTV, and higher the down payment, the lower the PMI rate; in accordance with the reduction in the lender’s risk.
Legislation Pertaining to Mortgage Insurance
The federal Homeowners Protection Act regulates PMI disclosure and discontinuation procedures. This Act requires lenders (or servicers such as mortgage brokers and loan officers) to automatically discontinue the mortgage insurance requirement once the borrower reaches 78% LTV, or 22% equity (if the loan is currently in good standing). This means that even if you are required to pay PMI initially, you have the right to stop paying the PMI once your LTV reaches 78%.