You`ve finally managed to scrape together a 5, 10 or 15 percent down payment plus closing costs. Then your lender hits you with the news that, on top of all that, you`ll have to pay for private mortgage insurance.
And you want to know why.
The reason is simple. Mortgage experts say that home buyers who make small down payments are more likely to default on their home loans than those who put down the traditional 20 percent of the purchase price. Therefore, lenders require those buyers to purchase private mortgage insurance, or PMI, to insure the lender against the extra risk-and ensuing costs-of foreclosure.
Conventional lenders modeled PMI after the type of protection provided by government-backed loans, those insured by the Federal Housing Administration and Veterans Administration. With a government-backed loan, the government guarantees to repay the lender up to 100 percent of the loan, should it go into default and the home be foreclosed upon.
With a similar guarantee on conventional loans, lenders began reaching out to buyers who didn`t have enough cash to put together a 20 percent down payment (now about 30 percent of home buyers), allowing many people to purchase property years earlier than they otherwise would have been able to.
Buyers who are required to purchase PMI have to pay for that added security, but they gain from being able get a mortgage with much less cash upfront.
In fact, according to Patricia Cunningham, director of consumer affairs of the Office of Commissioner of Savings and Residential Finance, an Illinois state agency that licenses mortgage companies, brokerage services and state-chartered savings institutions, regulations prohibit lenders from making a loan in excess of 80 percent of the purchase price without PMI to cover the top 20 percent of the loan.
”Basically, it provides lenders with enough insurance so they will make loans to home buyers who don`t have the qualifications to get a conventional loan on their own,” Chappelle notes.
The difference between putting down 20 percent and, say, 15 percent or even 10 percent wouldn`t seem to make such a substantial difference on the surface, but Chappelle says that the 20 percent down payment provides a necessary cushion for both buyer and lender.
”If I put down 20 percent and lose my job, and the house has declined in value, I can still sell it and pay off the mortgage and come out even or with a little bit of cash,” he says. ”But if I`ve only put down 5 percent in the same set of circumstances, then I`ll come out of the deal owing money.”
According to Emily Cesario, a mortgage broker with Illinois Home Mortgage in Itasca, buyers often confuse PMI with other types of insurance, including mortgage insurance that pays off the loan in the event of the purchaser`s death or disability.
But PMI covers only the top 20 to 25 percent of a loan and repays that amount to the lender, not the buyer, in case of default, she notes.
According to Mary-Carol Arado, an account manager and personal loan consultant for Corley Financial, a residential mortgage brokerage company in Chicago, fees for PMI are usually structured as a lump-sum upfront payment due at closing plus monthly installments of premium tacked onto a buyer`s mortgage. The lump-sum payment is usually equal to the total premium for the first year, which means buyers are always paying premiums for the year ahead. Also, lenders often require a two- or three-month cushion of premium payment that sits in an escrow account.
Arado says that fees for PMI fluctuate, depending on what type of mortgage the buyer has selected.
”For the first year of a fixed-rate mortgage, the pre-paid premium, which is paid at closing, can run between .40 to .50 of one percent of the buyer`s loan amount. An adjustable-rate mortgage is more expensive and can run from .44 to .60 of one percent of the loan amount,” Arado explains.
For example, if you need a $100,000 mortgage to purchase your $110,000 property, in the first year your PMI premium would be from $400 to $500.
”After the first-year fee is paid, the rate drops. For conventional, fixed-rate loans, the annual fee is usually .34 percent of the loan amount, which is then broken into 12 pieces and attached to the monthly mortgage payment. The annual fee for adjustable mortgages is around .44 percent of the loan amount,” she says.
For your $100,000 mortgage, the PMI annual fee would fall to $340 per year, divided into 12 equal payments of $28.33. That amount is attached to your monthly mortgage payment. It is important to note that PMI is always paid a year in advance. The first year`s premium is paid at closing, while monthly installments of premium are made with the very first mortgage payment.
Rate varies
According to Ray Hazucka, a mortgage banker with DMR Financial Services in Orland Park, the cost of PMI varies with the size of the loan and the amount of the down payment. PMI for a mortgage with a 5 percent down payment will be more expensive than PMI for a mortgage with 15 percent down, simply because the risk on the first mortgage is greater.
Instead of using PMI, some lenders insure low-down-payment loans themselves. Citicorp is the largest of the self-insuring lenders, and it keeps all of its residential mortgages in its own portfolio. Unlike many other lenders, it doesn`t resell mortgages on the secondary market to institutional investors such as Fannie Mae (the Federal National Mortgage Association).
This allows the lender to set its own guidelines for the insurance coverage rather than follow the pre-set guidelines of the institutional investor who is going to buy the loan.
Arado says that, instead of charging for PMI, self-insuring lenders will raise the buyer`s interest rate and points-a point equals one percent of the loan amount-to cover the cost of the insurance. ”They will promote this as being a better choice because it is then tax-deductible,” Arado says.
Self-insuring lenders might charge an extra .375 points for a conventional fixed-rate loan and add half a point to the annual interest rate. ”If a customer calls me and says (a lender) doesn`t charge PMI, I ask them to check the interest rate,” Hazucka says. ”It`s always 1/4 to 3/8 of a percent higher than ours. And you`ll be paying it for the life of the loan.”
The better deal
Which is a better deal for the buyer?
”I`ve worked for a self-insuring lender and a conventional lender and I have to say that PMI is the better deal between the two, even though self-insuring lenders say that because the fees are added into the rate and points, there is a tax advantage,” Arado says. ”I have worked out the numbers a couple of times and the tax advantage doesn`t cover the fact that the lenders added more to the cost (of the mortgage) than would have been added with a PMI premium.”
In addition to the generally higher cost, another problem with self-insuring lenders is that you can never lower the interest rate once you have accumulated 20 percent equity in your house.
At least with PMI, Arado notes, once you`ve been in your house for awhile and have built up some equity and seen some price appreciation, you can pay to have your house reappraised. If the lender sees that you then have at least 20 percent equity in the house and you meet its other qualifications, the lender will cancel your PMI.
But some lenders aren`t so eager to do so.
Borrower beware
”Usually the borrower should be very careful in signing any contracts at the outset and should make sure the paperwork shows precisely under which conditions their PMI should be canceled,” Cunningham notes.
She warns that the time to negotiate an end to PMI is when you`re making your loan application.
Although Cunningham says there is no federal or state legislation that requires lenders to drop PMI at a certain point in time, she says there was talk of proposing some kind of law that would regulate PMI according to a certain formula. That kind of a statute, she says, would be welcome.
”The problem is that if the buyer wants to drop the PMI because there has been tremendous appreciation in the area, the lender might say, okay, if the appraisal bears out, we`ll be glad to drop it. Or, the lender might not be interested because of volatile swings in the residential values of a community,” Cunningham explains.
”If you ask upfront about which conditions must occur for the PMI to be canceled, then everyone knows from day one what the story is. The homeowner knows how to plan and doesn`t get a rude shock when he gets turned down by the lender,” she adds.
Cesario says many buyers now ask their lenders for a letter stating that the PMI payments will stop automatically when the equity level reaches 20 percent. And, asking the lender for a disclosure statement at the time of closing should tell you how much you can expect to shell out for PMI over the life of the loan.
Although Hazucka says some lenders don`t like to release owners from their PMI because they collect interest on the premiums, Charles M. Reid, president and CEO of United Guarantee, one of the four largest PMI companies in the United States, says lenders are not supposed to use those funds for themselves.
”The lender can`t take that money and pay bills or lend it out. It must stay in an escrow account because it`s held in trust,” Reid explains. ”The lender collects the premium from the borrower, usually on a monthly basis, then remits it annually to continue the insurance.
Cunningham says PMI conflicts are not usually over whether to drop the coverage, but at what point.
”Buyers have to face the fact that in a number of areas, property values have depreciated. Traditionally in this country, there has been an old comfort that if you invest in real estate, you`ll always be okay. I`m not totally sure that`s true today,” she says. ”For years, most property appreciated either gently or dramatically. But there are a lot of areas where unemployment has put a lot of places on the market, and there are areas of the country where million-dollar mansions are going for $200,000.”
