You know that you need a down payment for a home when you're applying for a mortgage. But did you know that a small down payment may mean you need to purchase private mortgage insurance (PMI)? Learn what PMI is, how it works, and who needs it.
What is PMI?
Mortgage insurance protects your lender if you default on your mortgage. Home buyers who are putting down less than 20 percent will be required to purchase this insurance. If you own a home and you decide to refinance, you may need to purchase PMI if your established home equity is under 20 percent.
You'll pay a one-time premium for PMI, which is expressed as a percentage ranging from 0.6 to 4.5 percent of your mortgage. This premium can be paid upfront to keep your interest down, or added to your mortgage where it will increase the premium. PMI, also called mortgage loan insurance, offers no protection to home buyers. It is only intended to protect the lender from a buyer who stops making payments.
How Does PMI Work?
Home buyers who put down less than 20 percent of the home value must take out mortgage loan insurance for the difference between their down payment and 20 percent. Home buyers with poor credit, or home buyers who are self employed, may be required by their lender to take out mortgage insurance even if they are putting down 20 percent.
Your mortgage lender will let you know during the mortgage application process if you are required to take out PMI. You don't need to apply for mortgage loan insurance. If it's needed, your lender will make the arrangements. The PMI premium varies by the size of a down payment. If a home buyer is placing 5 percent down—and borrowing 95 percent—they will pay 4 percent in mortgage loan insurance premiums. If they are putting 15 percent down—and borrowing 85 percent—the premium would be 2.8 percent.
To determine the true cost of a mortgage loan insurance premium, multiply the amount of a mortgage by the interest rate. If you are borrowing $300,000 and must pay 2.8 percent in PMI, the true cost of the PMI premium is 2.8 percent of $300,000, which is $8,400. If a lender quoted 4 percent in PMI, buyers would pay 4 percent of $300,000 or $12,000. Residents of Ontario, Manitoba, and Quebec Province are taxed on their mortgage loan insurance premiums; this tax cannot be added onto the mortgage but must be paid when buyers receive the mortgage loan.
As this example illustrates, it's worthwhile to place more money down if that's an affordable option. Putting more money down can also reduce the cost of the mortgage loan interest, saving more money over time when buying your Springbank Hill home. It's also best to pay PMI up front; adding PMI premiums to the mortgage amount increases the mortgage by that amount. Buyers will pay more in interest every month for the life of the mortgage.
If you have any questions about mortgage loan insurance, ask your mortgage lender during the application process. Your mortgage lender can make sure you understand the way PMI works and whether or not you need it. Whether you decide to look for cheaper homes where you'll be able to put down more of a down payment, delay your home purchase until you've saved more money, or proceed with a mortgage that requires PMI, you'll feel prepared when you understand how PMI works.