How Private Mortgage Insurance (PMI) Works

Private mortgage insurance (PMI) refers to mortgage insurance offered by private companies.

The main distinction is to describe mortgage insurance not provided by government agencies under FHA and VA.

In the loan market, lenders who underwrite mortgages that exceed 80% loan to value requires the borrower sign up for PMI.

This can sometimes create unhappy customers as they had no intention to sign up in the first place, and especially when the premiums are not cheap.

How PMI works

PMI basically insures the top 20% of a loan against the prospect of a borrower going into default.

This means that should a borrower defaults and foreclosure ensues, the insurance provides coverage for up to 20% of losses incurred of the sales proceeds are insufficient to repay the outstanding debt.

For example, if the amount owed is $200,000 and the house is sold for $190,000, the lender can claim for the $10,000 reimbursement from the insurer by presenting the policy.

This is why PMI is required for loans that are above 80% LTV, and can be eliminated when the loan balance falls below 80% LTV, which would be discussed later.

Insurance premiums

Quotes for PMI premiums are often presented as annual rates with monthly payments.

And premium rates are determined by a variety of variables including:

Using a table segmented by loan amount as a percentage of the property’s appraised value or lowest sale price, a factor of between 0.01 to 0.99 can be determined.

With the factor identified, the monthly premium is calculated by multiplying the loan balance with the factor and divided by 1,200.

For example, if a $100,000 loan has a factor of 0.78, the premium rate would be ($100,000 x 0.78) /1200 = $65.

It should be noted that because the market is so competitive, premiums from different insurance companies tend to be approximately the same with little variance.

Upfront premium

A lesser known alternative of the monthly premium payment plan is the financed upfront premium plan.

This arrangement requires a one-time premium included in the total loan amount.

For example a $200,000 mortgage might increase to $205,000 after including the premium. This new amount will then be used as the base to calculate monthly installment payment amount.

Further more, a portion of that premium will be tax deductible.

The amount that qualifies for deduction will depend on the tax bracket which the borrower belongs to.

In general, when the upfront premium is converted to a monthly premium, we would usually find that it would be cheaper compared to a regular monthly premium plan.

Moreover, there are tax benefits unlike monthly premium plans that are not deductible.

The disadvantage of financed upfront premium plans is that it causes a higher loan balance amount when the loan is paid. This is after taking into account the partial refunds the borrower will enjoy during the early years of loan repayment.

With the advantages of upfront premiums over monthly premiums, the question is why not more borrower are signing up for them.

The problem is that Fannie Mae and Freddie Mac require lenders to be specially authorized to offer them on loans that are eventually sold to them.

So lenders avoid them and choose to stick to the tried and tested monthly premiums.

Consumers aren’t complaining about that anyway.

What they are complaining about are…

Why PMI premiums are not deductible

The simple answer is that the IRS said so.

The more complicated answer which opens a can of worms is that mortgage insurance premiums are payments for services (insurance policies) rendered by service providers (insurers).

This puts it in the same category as home inspection services, appraisal services, legal services, etc.

The challenges to this line of classification has been going on for years.

Yet with all the arguments with and without merit, IRS ultimately has the final say.

And they have spoken… again and again about this topic.

Economics of PMI

If given a choice, most borrowers would choose not to purchase PMI.

Because PMI becomes a requirement when a borrower borrower more than 80% LTV, a fair method of measuring the economics of PMI is to pit it against the excess of the loan over 80%.

Suppose you have a $80,000(80%) 25-year fixed rate mortgage at 7% with no points to buy a house priced at $100,000. With mortgage insurance, you can borrower up to $95,000(95%).

When you work out the numbers using the insurance premium factors, you might find that the interest cost of the $15,000 excess is significantly higher than that of the $80,000.

This financial phenomena is due to you paying the premium for the entire $95,000 instead of just the $$15,000.

This should serve as a hint to you to give PMI deeper thought before signing up for it.

Smarter borrowers, or at least those that think they are smarter are known to go to great lengths just to avoid PMI with second mortgage strategies.

It is certainly an avenues that you should explore too if you intend to borrower more than 80%.

Sometimes real estate investors and flippers even voluntarily sign up for PMI so that they can borrower up to 95% of the property value.

This is so that they can use the saved funds for more investments.

Why is it not the lenders who pay for PMI?

When we consider that the objective of mortgage insurance is more to protect the lender instead of the property owner, it makes sense to conclude that the lender should be the party paying for it.

Yet this is not the case in reality. Why do borrowers pay the premiums?

This is due partly to history and greed.

You jaw might drop to learn the reasoning and justification behind it. Are you ready?

When the PMI system was established in the 1950s, many state still practice interest rate ceiling to prevent consumers from paying for rate that are spiraling out of control.

If a lender was to pay for PMI for the buyer, they would factor in that extra cost into their home loans in the form of higher interest rates. This might prevent them from achieving maximum profitability.

Moreover a higher interest rate will be factored into credit assessment, which can to the detriment of borrowers, pull down approved loan amounts.

If borrowers paid for the insurance premiums, these problems will be eliminated. And borrowers will presumably enjoy lower interest rates.

And this practice has flowed down the years to today.

However from my experience, when a company or industry passes costs to consumers for the reason of keeping prices down, the consumers are always the one to suffer in the long term as prices will be quietly increased regardless.

The proof is in the pudding.

There are so many things wrong with the borrower-pay system that I don’t know where to start.

Firstly under the modern PMI system, borrowers don’t get to choose and decide which insurer to go for but instead have the decision made for them by the lender.

This is because the lender has to be comfortable with the insurer they do business with.

This lack of competition can only be detrimental to borrowers as insurers will have no motivation or incentive to deliver more value or a lower price against competitors.

What insurers are competing for however, are for the patronage of lenders since lenders are the ones doing the selling for them. But lenders, who have the most leverage over PMI providers, have little interest (if any at all) to minimize the premiums of borrowers. Their interest is in the maximum protection of their loans from defaulters.

As anyone with an able mind can see, the dynamics in this whole relationship is skewed towards anywhere other than the borrower.

With a lender-pay system, lenders can buy policies in bulk, making it more affordable to borrowers.

Even if the costs of mortgage insurance is factored into interest rates, resulting in higher rates, the total cost to borrower would still be lower than the combined cost of premiums plus interest under the borrower-pay system.

In addition to that, by factoring the insurance costs (in the form of interest rates) into the mortgage payments, the premiums become tax deductible.

When we weigh up these pros and cons, it is clear that a lender-pay system would benefit consumers more than a borrower-pay set up.

But as we would have it, nothing will change in the near future. If ever.

The argument against this, and I agree that this is a strong point, is that when premiums are added to the mortgage payments in the form of extra interest, it would last for the entire life of the loan.

The implication of this is that a borrower would continue to pay premiums for private mortgage insurance even if the policy is terminated.

However, a simple solution to this is to recast the loan without PMI when PMI is cancelled.

It’s amazing how lenders are pretending that there is no easy solution to solve this and that a genius physicist who has won at least one Nobel Price might be needed to solve this equation.

But therein lies an even more disturbing issue…

How the heck does one terminate PMI?

It used to be that borrowers can only terminate PMI with the expressed permission of the lender.

That was until 1999 when federal law changes were made to address the problem that consumers are being taken for a ride by lenders and insurer.

After all if PMI is a necessity for loans above 80% LTV, common sense says that it should cease to exist when amortization has reduced the loan principal to 80% of the original property value.

But that’s not how lenders and insurers work.

Try telling a bank that the interest on your personal loan should decrease because the Federal Reserve has cut interest rates and see how it goes.

Lenders have no incentive to release a borrower from PMI as they had legitimately signed up for it under the stated terms in the first place.

But under the 1999 legislation, loans made after 29 July 1999 will have PMI terminated automatically once it’s loan balance hits 78% of the appraised property value at the time the loan was made.

On top of that, when loan balance reaches 80%, PMI has to be cancelled when the request is made by the borrower. However, certain conditions has to be met for this clause to be valid.

Loans made before 29 July 1999 will not be subjected to these rulings.

Exceptions are made to loans sold to Fannie Mae and Freddie Mac. Regardless of when these loans were issued, they will enjoy the privilege of the 1999 law.

And the current value of the property can be taken into account rather of the old one. There’s a good chance that the house has appreciated.

The general advice is that if your mortgage is already 2 years old, conduct a check to see if you have hit 80% and eligible to cancel PMI.

There is little point in paying for something that you don’t have to.