Role of Private Mortgage Insurance

Freddie Mac defines PMI as:

“An insurance policy that protects the lender if you are unable to pay your mortgage. It’s a monthly fee, rolled into your mortgage payment that is required for all conforming, conventional loans that have down payments less than 20%.”

One of the biggest challenges for a homebuyer is saving enough money for the down payment. Many potential homebuyers mistakenly believe that they have to have a 20% down payment to purchase a home.

It is this belief that often adds months and sometimes even years before they can save enough money to buy their first home.

The down payment amount is described in percentage terms compared to the sale price of the property.  For example, on a home price of $175,000 using an FHA loan with a 3.5% down payment, the homebuyer would have to put down ($175,000 X .035) = $ 6,125.00 as the down payment on the home.

Depending on the mortgage program you are applying for, there is a specified minimum down payment amount.

Down Payment Requirements for Types of Loans

• FHA Loan: 3.5% down payment minimum
• VA Loan: No down payment required
• Conventional Loan (with PMI): 3% minimum
• Conventional Loan (without PMI): 20% minimum
• USDA Loan: No down payment required
• Jumbo Loan: 10% down payment required

The Federal Home Loan Mortgage Corporation – acronym Freddie Mac is a public government sponsored enterprise.  It was founded in 1970 to expand the secondary mortgage market for mortgages in the United States.

The purpose of the corporation is to buy mortgages on the secondary market.  It then pools them and sells them as mortgage securities to investors on the open market, thereby, increasing the supply of money available for mortgage lending in the U.S.

Fannie Mae is the acronym for the Federal Home Loan Mortgage Corporation.  A U.S. government-sponsored enterprise, it was founded in 1938 after the Great Depression as part of the “New Deal.”

A leading source of financing for mortgage lenders, Fannie Mae’s purpose is to expand the secondary mortgage market by securitizing mortgage loans.  This allows lenders to reinvest assets into more lending.

Fannie Mae and Freddie Mac worked to develop uniform mortgage documents and mortgage standards for what has become known as a conforming loan.

Conventional loans are loans that conform to Fannie Mae and Freddie Mac mortgage standards.

Any loan that does not meet these guidelines is a non-conforming loan.

Understanding Mortgage Default

To understand why conventional loans require PMI, think about what happens during a mortgage default.

In some states, it takes 2 years or more before the bank can reclaim the property.  During this time, the home may have incurred major damage and may show signs of deferred maintenance.  By the time the home is eventually sold in foreclosure, it is likely that the lender has incurred a real loss related to the home’s condition and missed payments.

During the process of default and foreclosure, the bank will typically lose twenty percent of a home’s value. This explains the requirement to put 20% down.

Putting less than 20% down puts the bank at risk. This is where Private Mortgage Insurance comes into play.

It enables borrowers to purchase homes with less than 20% down by carrying Private Mortgage Insurance to protect the bank in case of default.

Because the borrower pays for this insurance, the lender is willing to underwrite loans with less than 20% down.

Source Freddie Mac:

“The cost of PMI varies based on your loan-to-value ratio – the amount you owe on your mortgage compared to its value – and credit score, but you can expect to pay between $30 to $70 per month for every $100,000 borrowed.”

Factors Determining PMI Premium

• Home’s Value
• Down Payment Amount
• Your Credit Score

On conventional loans, the PMI can be removed from your mortgage payment once you have obtained 20% equity in your home.  Home equity is the monetary difference between what your home is worth on paper and what is owed on it to the lender.

Historically, home appreciation rates are between 3% to 5%.  In the 2018 Annual Report from the 11-County Piedmont Triad Region, Davidson County home prices increased by 7.3% in 2018 ($161,000) compared to 2017 ($150,000).  From 2014, there was a 28.8% increase ($125,000).

Forsyth County home prices increased by 7.6% in 2018 (169,900) compared to 2017 ($158,000).  From 2014, there was a 24.7% increase ($136,370).

The National Association of Realtors reports that the average down payment for all buyers in 2018 was 10%.  For first-time buyers, the number dropped down to 6%, while move-up buyers (repeat buyers) put down 14%.

Here is an example of the cost of a mortgage on a $200,000 home with a 5% down payment and PMI, compared to a 20% down payment without PMI.

** Principal & Interest Only – does not include homeowner’s insurance & taxes

Source:  Freddie Mac

You will notice that there is a $ 249.46 difference between the two payment options.  A down payment of 5% carries a PMI monthly premium of $104.50. The other added amount to this option is the additional amount borrowed of $30,000 which adds $144.96 to the monthly premium.

With the second option, you would need to save $ 40,000 as your down payment. If you are purchasing your first home, $40,000 is a large sum of money that takes discipline and sacrifice to save for. Many first time buyers save 5 to 10 years before buying their first home.

The problem with saving for a 20% down payment is that it can take a long time to accumulate enough money in savings.  In the meantime, home prices are appreciating and interest rates will probably increase.

For many buyers, it could prove much cheaper and quicker to opt for the 5% down payment mortgage with PMI.

FHA and USDA loans come with their own version of mortgage insurance or government-sponsored mortgage insurance. Government Mortgage Insurance has the same purpose as Private Mortgage Insurance.

FHA mortgage insurance rates are usually lower but are due over the life of the loan. That would make this type of mortgage insurance more expensive. However, most homeowners with an FHA mortgage loan refinance into a conventional loan after several years.

USDA mortgage insurance requires zero down payment but comes with mortgage insurance that costs up to two-thirds less than private mortgage insurance.

Difference between the three major types of mortgage insurance based on a purchase price of $250,000 and varying credit scores.

Homeownership is the primary means of wealth building in the United States.  Private Mortgage Insurance is a vehicle that allows homebuyers to purchase homes sooner rather than later.

If you have any questions about whether you should buy now or wait until you have saved a larger down payment, meet with a professional in your area who can explain your market’s condition and advise you in making the best decision for you and your family.