If you want to buy a house but can't pay 20% of the cost upfront, a lender will want you to have private mortgage insurance. PMI protects the lender from loss if you can't make payments on a loan with less than a 20% down payment.
PMI increases a borrower's monthly mortgage payment, which is why most borrowers don't want to shoulder it. Short of saving up a sufficient down payment, however, there are only a few ways to avoid PMI or get rid of it.
1. Take Out a Second Mortgage
One way to avoid PMI is to take out what's sometimes called a piggyback loan or an 80-10-10. In this scenario, you'd take out a mortgage for 80% of the value (so it doesn't require PMI), make a 10% down payment and take out a second loan for the remaining 10%. You could borrow that 10% in the form of an installment loan or a home equity line of credit.
"It's not always a good idea," said Casey Fleming, a mortgage adviser for C2 Financial Corp. and author of "The Loan Guide." "If you use two loans, you will avoid mortgage insurance, but you should go in with a plan to get rid of the second mortgage as soon as you can. … Second mortgages are expensive."
Whether an 80-10-10 is a smart option for you depends on a lot of factors, Fleming said, but it's something to know about.
2. Have Your Lender Pay for It
Lender-paid mortgage insurance is what it sounds like: Your lender pays the insurance company instead of you. The lender will bump up your interest rate to cover the cost, so even though you're not paying the mortgage insurance directly, you're still paying for it by way of interest.
"The justification for doing this is [the homeowner] can deduct all of the interest, where mortgage insurance is not readily deductible," Fleming said.
The important thing to note here is you can get rid of mortgage insurance, but you're stuck with the interest rate for the life of the loan.
3. Ask Your Lender to Remove It
The Homeowners Protection Act requires lenders to remove PMI from a loan after the loan balance has fallen to 80% of the home's original purchase price, but there's a way to get rid of it quicker. Keep an eye on your home's value. When your home appreciates in value, your loan balance becomes a smaller percentage of your home's total value. Once your remaining loan balance is at or below 80% of your home's current value, you can ask your lender to remove PMI.
"As soon as you believe you've got 20% equity, that's the point at which you should think about contacting your lender," said Joe Parsons, senior loan officer at PFS Financing in Dublin, Calif. You will need to pay for an appraisal, and depending on the kind of appraisal your lender requires and where you live, that appraisal could cost several hundred dollars. Parsons recommended using a real estate site like Zillow to keep track of your home's value. That can help you avoid wasting money on an appraisal when your property may not yet have appreciated enough to get rid of PMI.
Parsons said he's encountered people who have paid PMI for years longer than they needed to, so it's important borrowers know to pay attention to property values and ask their lenders to remove it when the time is right.
Another thing to know: Most contracts require the borrower to pay PMI for at least two years, regardless of home value, Fleming said.
Asking your lender to remove PMI isn't always an option. For example, FHA loans require mortgage insurance for the life of the loan. In that case, the only way to get rid of it would be to refinance. You could also refinance a conventional loan with insurance to a loan without it.
"In some cases where the rates have decreased, then it can make sense to refinance, even if the rate is only dropping a quarter or half a percent," Parsons said. The lower rate, combined with the savings of eliminating PMI, can save the borrower money. Keep in mind there are costs associated with refinancing, and you reset the clock when you take out a new loan.
Parsons and Fleming mentioned refinancing as a way to get rid of insurance only when mortgage rates have gone down.
"I wouldn't refinance just to get rid of the [PMI]," Parsons said. "Usually there's a cheaper way."
Another way to avoid mortgage insurance is to take out a VA loan, but that's not an option for every borrower.
There are dozens of factors to consider when deciding how and when to borrow to buy a home. As you figure it out, one of your top priorities should be to build good credit, because it will heavily factor into your mortgage approval and pricing. To see where you stand, you can check your free credit score every 30 days on Credit.com.
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