If your down payment on a home is less than 20% of the appraised value or sale price, you must obtain private mortgage insurance (PMI).
Private mortgage insurance, or PMI, is different from FHA and VA insurance, which is run by government programs. The cost of mortgage insurance varies depending on the size of the down payment and the loan, but it typically amounts to about 0.5% of the loan.
With mortgage insurance, the borrower pays the premiums, but the lender is the beneficiary. The coverage protects lenders against the borrower's default. If a borrower stops paying on a mortgage, the insurance company ensures that the lender will be paid in full.
Mortgage companies pick insurance providers for their customers, but the borrowers have to foot the bill. Usually, they do so in monthly installments. But some lenders offer programs whereby the borrower pays the entire insurance premium in a lump sum at closing.
Say you put down 10% ($15,000) on a $150,000 house. The lender multiplies the 90% loan, or $135,000, by 0.5%. The result is an annual mortgage insurance premium of $675, which is then divided into monthly payments of $56.25. Home buyers must maintain the premiums until they cross the one-fifth-of-principal threshold, which can take years in long-term mortgages.
A homebuyer has to keep paying mortgage insurance premiums until the principal balance is paid down to a certain percentage of the home's original value. There are a couple of ways to avoid mortgage insurance. Each has its own benefits and drawbacks.
Some lenders will waive the mortgage insurance requirement if the buyer accepts a higher interest rate on the mortgage loan. The rate increase generally ranges from three-quarters of a percentage point, or 75 basis points, to a full percentage point, depending on the down payment. Borrowers can benefit from this because mortgage interest is tax deductible, whereas mortgage insurance premiums aren't. But they'll end up paying more interest over the life of their loan due to the higher rates.
This program involves getting two loans. The borrower gets a first mortgage equal to 80% of the sale price, gets a second mortgage for another 10% of the price, and puts the remaining 10% down at closing. The second mortgage has a higher interest rate. But since it applies to 10% of the total loan, the monthly payments on the two mortgages can still be lower than the monthly payment on one home loan with mortgage insurance. Plus, interest on the second mortgage is tax deductible. The 80-10-10 loan isn't the only plan available; borrowers can get 80-15-5 loans or other combinations.
Let’s look at an example. If we compare the purchase of a $150,000 home under the 80-10-10 plan to a standard fixed mortgage including mortgage insurance, we find that the former is $35.36 cheaper each month.
Here's how it works: Under the 80-10-10 plan, the 10% down payment on a $150,000 house is $15,000. The first mortgage is $120,000 at 7%, which comes to a monthly payment of $798.36. The second mortgage for $15,000 has a 9% interest rate, making a monthly payment of $120.69. The total monthly payment for both loans is $919.05.
With a $15,000 down payment, one mortgage of $135,000 at 7% has a monthly payment of $898.16, plus mortgage insurance of $56.25, making a total payment $954.41.