Private Mortgage Insurance (PMI)

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Lenders can give you a loan with a smaller down payment but this also increases their lending risk. With a lesser amount of your cash in the deal, there is also less of a guarantee that should times get tough, you won’t walk away and leave the lender with an unpaid mortgage and the deed to your home. The home might even be worth less than it was the day you bought it if your local economy really turns sour. To lessen the risk, the lender will force you to pay for private mortgage insurance or PMI. You pay for this insurance with the premium added to your monthly payment, but the lender is the beneficiary. If you were to default on your loan then the lender would be paid cash. PMI is not tax deductible and it costs about 0.5 percent of your mortgage balance per year or about $2,000 on a $400,000 loan.

But you don’t have to keep paying PMI forever. If property values in your area have been rising quickly and you’ve made payments faithfully for at least two years then you may be able to convince your lender to drop the coverage requirement. Rising values may have boosted your equity enough that the insurance is no longer justified. As the years go by, your loan balance slowly shrinks while your property’s value increases. Because most of your payment in the early years of a mortgage goes toward interest then your loan balance shrinks slowly during the first ten years of the loan. However in late years, more of the monthly payment is used to pay off principal and your loan balance declines much more rapidly. Most of the equity you build up in the early years is thanks to rising market prices which is also called appreciation.

If you want to avoid PMI, many lenders offer low-down payment mortgages without a separate PMI requirement. These are a fine choice but don’t be fooled into thinking there’s really no PMI. It’s actually there though the lender has simply incorporated it into the interest rate. You’ll pay a higher interest rate on these loans. The benefit is that the interest is tax-deductible whereas PMI is not. The drawback is that the only way to get out of this higher interest rate is to refinance. But if you’re likely to refinance in a few years anyway, or to move out of the home altogether then who cares that the PMI is built into the interest rate for thirty years? You and that loan will have long since parted ways.

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