As with most any product, service or rule that exists primarily to protect lenders, private mortgage insurance, or PMI, gets a bad rap. PMI is a risk-management product that protects lenders against loss if a borrower defaults, and is typically required for loans with loan-to-value percentages in excess of 80 percent.
But is that bad reputation deserved? While opting for PMI can certainly be a bad choice in the wrong circumstances, if used correctly it can open up new and exciting opportunities for potential buyers.
But how can those potential buyers tell the difference between a situation where they should pay PMI and one where they should hold off? Read on to find out.
When to Pay PMI
When you find a great deal. Finding a great deal on a house you love may seem impossible depending on your area. So when it happens, you may want to bite the bullet and jump on the deal. Depending on how much you save, it may be worth more in the long run to pay PMI up front and enjoy the home's appreciation later on.
When you are close to a 20 percent down payment. If you're religiously saving for a down payment and find your perfect house, it may be better to seal the deal now than wait until you have your full 20 percent saved. You can make sure that the PMI will fall off automatically when you get enough equity, or you can contact the lender to ask them to remove it.
When you need a savings cushion. While putting down a 20 percent down payment is ideal, it can require depleting all your savings. Instead of having no cash reserves, it's better to pay PMI every month and still have your emergency fund. You never know what will happen – you may lose your job, the house might need a new roof or your kids might suddenly need braces. Paying PMI and having some savings in the bank will give you more flexibility than having more equity in your home.
When to Avoid PMI
When you barely have any equity. Nowadays, lenders are offering homes with as little as 3 percent down. While that makes home buying more accessible, it also makes it harder to get rid of PMI. If you're having trouble saving for a full down payment, you may be better off waiting to purchase a home. Annual PMI costs are around 0.5-1 percent of the home's total cost, and if you have a small down payment it's probably best to wait until you can afford to put more down.
When the loan payment is too much of your monthly salary. General finance experts say that your monthly mortgage or housing cost should only be a third or less of your net income. It's a bad idea to buy a house if adding PMI to that total will bump you over that 30 percent mark.
- When you'll have to refinance to get rid of PMI. While some lenders automatically drop PMI once you reach 80 percent equity in your home, some require that you refinance your home to get the PMI dropped. A refinance can cost between 3-6 percent of the home's value, so it may be more costly to pay the PMI every month and then pay for a refinance later.
Ultimately, whether you choose to pay PMI or not is up to you. You'll have to weigh the pros and cons and look at your unique situation to make the most informed decision. And, once you do decide to purchase a home, make sure to shop around for the best lender to get the best deal on your home loan.