When buying a home, most financial experts recommend a 20% down payment.
Why? It’s partly because of private mortgage insurance (PMI), an extra monthly fee on top of your mortgage that lenders require when you pay less than 20% down on a home.
There is no doubt PMI makes homeownership more expensive, often by hundreds of dollars a month. But for those looking to take advantage of record low mortgage rates, but don’t have the liquidity for 20% down payment, PMI can help homebuyers take out a mortgage with much lower upfront costs.
If you are going the PMI route, you might not know you have options when it comes to taking PMI. You’ll still pay extra, but you can choose the option that best works in your favor.
What Is Private Mortgage Insurance (PMI)?
Private mortgage insurance, also called PMI, is a type of insurance that protects the lender if you default on your loan payments. Conventional loans usually require PMI when your down payment is less than 20%. Lenders do this to cut down on risk, says Matt Metcalf, a Denver-based real estate broker.
“A larger down payment means if [the lender is] forced to foreclose for lack of payment, they have a better chance of recovering the full loan amount and the costs associated with the foreclosure,” Metcalf says.
There are four different ways to pay for PMI on a conventional loan (mortgage insurance on an FHA and USDA loan works differently):
- Monthly PMI: The lender takes out an annual mortgage insurance premium, divides up the cost, and bakes it into your monthly mortgage payments. You can eventually ditch PMI payments once you have 22% equity in your home.
- Single-premium PMI: You pay one upfront mortgage insurance premium at closing.
- Split-premium PMI: You make a small upfront PMI payment in addition to monthly PMI payments.
Lender-paid private insurance or LPMI: The lender pays the mortgage insurance policy, but they’ll usually make up for this cost through a higher interest rate.
How Lender-Paid PMI Works
With lender-paid PMI, the lender takes out a mortgage insurance policy and pays for the premium. To recover costs, the lender usually drives up the borrower’s interest rate.
A borrower with excellent credit might see their interest rate increase by about 0.25%, says Ashley Luethje, a mortgage loan originator at Paramount Residential Mortgage Group Inc. in Nebraska. Someone with moderate credit might pay 0.625% more. Of course, “there are numerous risk factors that could cause variations in this number,” she says.
The thought of paying a higher interest rate might make some homeowners squirm. But “a change in rate often has a lot less impact on a monthly payment than the mortgage insurance does,” says Nicole Rueth, producing branch manager with the Rueth Team of Fairway Independent Mortgage Corporation in Colorado. “It’s not an emotional decision. It’s a math decision.”
LPMI Vs. PMI
When comparing mortgage offers, you’ll need to see if LPMI works in your favor by calculating the monthly principal and interest of the mortgage with — and without — LPMI.
First, ask your lender two questions:
- How much will my interest rate increase if I accept lender-paid PMI?
- How much will I pay each month with borrower-paid monthly PMI?
Then, do the math.
Take a look at one example using NextAdvisor’s mortgage calculator. Let’s say you buy a home valued at $300,000. You put down 10% and receive an interest rate of 3% for a 30-year loan. Before considering mortgage insurance at all, the principal and interest (P&I) portion of your mortgage would equal $1,138 per month.
- With lender-paid PMI: The lender offers you LPMI and says your interest rate would increase from 3% to 3.5%. That pushes your monthly P&I cost from $1,138 to $1,212.
- With borrower-paid monthly PMI: Your lender quotes you $150 per month for borrower-paid PMI. Your monthly P&I would now increase from $1,138 to $1,288.
In this example, LPMI offers an advantage because you save $76 a month. “But it all depends on very specific scenarios for that client,” Rueth says. That’s why you’ll need to go through different scenarios with your lender.
When comparing LPMI versus PMI, it’s essentially comparing a higher interest rate to not having PMI payments. Work with your lender to see which one makes the most financial sense.
The Pros and Cons of LPMI
Lender-paid private mortgage insurance comes with its own set of advantages and disadvantages. To come out ahead, consider these pros and cons — then ask your lender to break down different options for you.
- May help you save money. Your interest rate may increase if you accept LPMI, but the cost is often cheaper than a monthly borrower-paid premium.
- Could help you qualify for the mortgage. Because LPMI usually costs less than borrower-paid mortgage insurance, your monthly payment could be more affordable.
- LPMI is built into the loan. That means you’re paying the higher interest rate for the duration of your loan term, even when your home equity exceeds 22%.
- You might pay more in the long run. Because you keep the higher interest rate for the life of the loan, you could eventually pay more interest with LPMI than with monthly borrower-paid PMI. “This is particularly an issue with longer-term loans with less down payment,” Luethje says. “PMI generally falls off the loan at 78% loan to value; LPMI will stay for the life of the loan.”
Borrowers usually point out that second drawback, Rueth says. “The borrower-paid mortgage insurance will fall off, while the interest rate is forever.” But for those who plan to move out within a few years, the slightly higher interest rate becomes less of a concern.
Alternatives to LPMI or PMI
Working with the right lender can help you understand all of your options. If you’re uncomfortable paying PMI, here’s what else you can do:
Active-duty service members, veterans, and surviving spouses of service members may be eligible for this type of mortgage.
Backed by the Department of Veterans Affairs, VA loans don’t require a down payment or mortgage insurance. But borrowers usually pay a funding fee equal to 1.4% to 3.6% of the purchase price, which works a lot like a down payment.
“If the veteran is on disability, even partial, they can usually get the funding fee waived completely,” Metcalf says.
Use a Second Mortgage
Another way to avoid lender-paid PMI is to take out a primary mortgage for 80% of the purchase price and a second mortgage for 10%. You cover the remaining 10% on the loan.
That second mortgage is usually a home equity line of credit, which could come in handy later. “If you pay it down, then you have a line of credit that you can tap into whenever you need remodeling or anything,” Rueth says.
Consider whether you’re OK with having a second mortgage payment, which could make the total cost of your financing the same as if you used lender-paid PMI or borrower-paid PMI.
Pay a Single Premium
You can choose to pay a single premium mortgage insurance upfront instead of making monthly payments. This is “a one-and-done option, but it can be a large amount depending on your down payment,” Metcalf cautions.
Negotiate With Seller
A cheaper move? “You can get the seller to prepay the mortgage insurance on your behalf through a seller concession,” Rueth suggests.
Use a 20% Down Payment
If you can swing it, consider saving up for the 20% down payment at closing, so you avoid mortgage insurance altogether. Just make sure you have enough cash left to cover closing costs and keep reserves for a financial emergency.
“I wouldn’t scrape together every penny just to get to the 20% mark,” Rueth says. “There’s nothing more uncomfortable than being house poor.”