When it comes to the words mortgage insurance, many people have a negative reaction because they think it is bad. Mortgage insurance bad? Maybe maybe not.
Mortgage insurance is required when the down payment for a home is less than 20% of the home’s purchase price. This can happen if the home buyer doesn’t have enough cash for the down payment or simply because they want to keep some cash for repairs, remodeling, etc.
The great thing about mortgage insurance is that it allows people to own a home even if they don’t have enough money for a down payment. But of course there is a price tag in the form of private mortgage insurance (PMI).
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What is PMI?
PMI is a type of insurance required by lenders as a condition of a mortgage loan. Borrowers pay for this insurance with a third-party mortgage insurer. This type of insurance protects the lender in the event that the borrower does not pay and defaults on the loan. It is an additional cost that a borrower has to pay on top of his mortgage.
The PMI costs depend on the borrower’s credit score, loan term, down payment, and mortgage. Borrowers must make the monthly payments until they have built up enough equity in the home, approximately 22% of the home’s purchase price. Once that is achieved, you no longer need to have a PMI and you will no longer have to pay.
But one thing many people don’t know is that it’s possible to avoid paying mortgage insurance on a loan by restructuring payments using lender-paid mortgage insurance (LPMI).
What is LPMI?
LPMI is normally only available for conventional loans. The idea of an LPMI is relatively simple: The lender buys the mortgage insurance and the homeowner accepts a higher interest rate on their mortgage loan. What happens is that the monthly loan payment increases, but usually it is not as much as with a PMI.
Another benefit of LPMI is that the mortgage interest deduction is tax-deductible for applicants who itemize their deductions. And as the interest rate on the loan gets higher, it is possible to get a higher mortgage interest deduction. That could mean getting more money back during tax time.
And if you do the math, it’s possible that getting an LPMI for a loan can save you a ton of money on each month’s mortgage payments.
One of the problems with LPMI is that, technically, the homeowner shall pay the insurance; the structure of payments simply changes. Instead of the normal insurance payments, the homeowner either pays a lump sum up front or makes a larger payment each month. In either case, however, it may be less than obtaining a PMI separately.
LPMI example: conventional mortgage loan
Here’s a simple example of what LPMI might look like for a conventional mortgage loan.
- $200,000 purchase price
- 10% deposit
- 750 credit score
- 30 year fixed rate of 4.875%
Option 1: standard monthly MI
- $971 principal & interest
- $84 monthly mortgage insurance84
- $1,055 total
Option 2: Borrower or seller prepaid premium is $3,574
- $971 principal & interest
- monthly savings of $84
- $9,504 10-year savings
Option 3: Borrower takes a higher interest rate of 0.375% or 5.25% in exchange for no monthly MI
- $1,013 principal and interest
- $42 monthly savings
The benefits of LPMI
- Monthly Savings. Mortgage insurance is spread over the term of the loan, so home buyers may not pay as much monthly, especially at the beginning of the loan.
- Eligible to borrow more. Another benefit to LPMI is that borrowers can actually qualify for a larger mortgage because their monthly payments are lower.
The Disadvantages of LPMI
- Cannot be canceled without refinancing. Since the LPMI is baked into the loan, it is not possible to pay it off unless the homeowner pays off the entire mortgage (which is easier said than done) or refinances the loan.
- Interest Rate Increases. The rate can increase over time and may end up costing more than a PMI would.
- Often requires good credit. Having an extremely good credit rating is one of the requirements to qualify for an LPMI. Lenders consider this because the higher the credit score, the less likely the borrower will default on the loan. It is something the lender will consider before agreeing to an LPMI.
- Not all lenders offer LPMI. If the homebuyer plans to pay less than 20% and needs to apply for an LPMI, make sure the lender offers LPMI. (It should actually be one of their first questions.) But there are lenders that don’t require any mortgage insurance, so home buyers should do their research.
How to Get Rid of LPMI
The LPMI is non-cancellable and must be paid over the life of the loan. The only way to reduce payments is to refinance the loan.
Once the homeowner reaches 20% equity, they can request a refinancing to lower the interest (and monthly payment) from their current lender or another.
Mortgage insurance costs a little extra, but it allows home buyers to buy a home and move into a home sooner rather than later. The insurance lowers the risk for lenders, but increases the chance of home ownership.
Is LPMI the right choice? The monthly savings can be dramatic and it can be the difference between qualifying for the home and not qualifying. Home buyers should work with their loan officer so that they are fully informed and can make the best decision for their situation.
More about mortgages from Pyjama People
Financing real estate can be one of the biggest challenges for new and experienced investors alike. This section of the Pyjama People blog is your resource for financing that next real estate transaction. Whether this is your first mortgage or your 100th, the articles on this page can help you decide what is the right financing approach for you. Investors with unusual or specific circumstances can also seek more direct feedback, or ask specific questions about their situation in the Creative Real Estate Finance Forum. Furthermore, Brandon Turner recently wrote: The book about investing in real estate with no (and little) money. This is a great resource for those looking to buy real estate without waiting to qualify for conventional financing.
Mortgages and creative financing