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Private Mortgage Insurance: Understanding the Important Factors  

Article By: Suvadip Das

The Purpose of Private Mortgage Insurance (PMI)

Several years ago, lenders did not lend more than 80% of the appraised value of the home underlying a residential mortgage loan due to the dramatic increase in the default risk associated with high loan-to-value mortgages. As a result, many individuals with a down payment of less than 20% found themselves unable to finance the purchase of a home.  However, Private Mortgage Insurance has made it possible for many of these individuals to become homeowners.

Lenders typically demand Private Mortgage Insurance on conventional mortgages including private mortgages that have loan-to-value ratios of greater than 80% and are sold on the secondary market. Private Mortgage Insurance protects the holder of a mortgage from complete loss in the event that a borrower defaults on the mortgage. The mortgage insurer might take all or part of the default risk in exchange for consideration: a premium. While the lender enjoys the protection of the Private Mortgage Insurance, it is the borrower who pays the Private Mortgage Insurance premium. Currently, Private Mortgage Insurance premiums can be as high as $1,500 per year for a mortgage on a $200,000 home.

PMI Premiums: Past and Present

In the past, a significant charge for Private Mortgage Insurance was made at the beginning of the mortgage. However, the premium payment structure for Private Mortgage Insurance premium has significantly changed during the last several years. Instead of charging the cost of PMI at closing, these premiums are spread out over the life of the mortgage. This change has made the elimination of future Private Mortgage Insurance premiums an attractive option for first time homebuyers with a down payment of less than 20%.

Currently, the monthly premium for Private Mortgage Insurance for the first 20 years of a 30-year mortgage varies with the size of the down payment. For a mortgage with a loan-to-value ratio of 95% (a down-payment of 5%), a typical monthly Private Mortgage Insurance premium is 0.78%/12 of the initial mortgage amount. A 90% loan-to-value ratio (a down-payment of 10%) requires a monthly premium of 0.52%/12 of the initial mortgage amount, and a mortgage with an 85% loan-to-value ratio (a down-payment of 15%) requires a monthly premium of 0.32%/12 of the initial mortgage amount. Beyond 20 years, the monthly Private Mortgage Insurance premium changes to 0.20%/12 of the initial mortgage amount, irrespective of the size of the down payment. In each case, the insurer at the beginning of the mortgage collects an escrow equivalent to two months’ premium.

One noticeable aspect of Private Mortgage Insurance is that, when determining the premium, the insurer normally does not take into account the true difference in default risk from one mortgagor to another. In most cases, the insured is evaluated simply as being either an acceptable or unacceptable risk. However, beyond being either an acceptable or an unacceptable risk, no consideration is given to the financial stability of the mortgagor. The premium paid for Private Mortgage Insurance is determined solely by the amount of the mortgage and the size of the down payment made by the mortgagor. (Its size affects the amount of a potential claim.) Therefore, with equally priced homes and equal down payments two insurable mortgagors pay the same Private Mortgage Insurance premium, regardless of the true default risk of one relative to the other. As a result, a mortgagor who is considered a low default risk is subsidizing the Private Mortgage Insurance premiums of other, higher default risk mortgagors.

The Value of an Investment in Home Equity

In evaluating the home equity investment decision, this article explores the effects of Private Mortgage Insurance on the portfolios of two different groups: (1) those obtaining a mortgage (whether by purchasing a new home or refinancing their current home) and (2) those who already own a home and are currently paying Private Mortgage Insurance as a part of their monthly mortgage payment. Although Private Mortgage Insurance is necessary and beneficial to many individuals, we conclude that some individuals purchasing or refinancing probably should avoid paying any Private Mortgage Insurance premiums. Similarly, many homeowners who initially were required to purchase Private Mortgage Insurance should terminate the PMI as soon as it is feasible financially. With an assumption that an individual has the funds needed to make the minimum down-payment that is required to secure a home mortgage, another premise of our discussion is that he or she has additional cash which can be invested in either home equity or other investments. Such an individual has the option of making the minimum down payment and investing the remaining cash in other assets or making a larger down payment.

To determine the attractiveness of one investment option relative to the other, the risk and returns of both options must be estimated. Ignoring the cost of Private Mortgage Insurance and the home mortgage interest tax deduction, the after-tax return on an additional investment in home equity is simply the mortgage rate of interest. Although returns of other investments may be as attractive as the mortgage rate of interest, the risk of many of these investments may be much greater.

With the current low mortgage rates and recent gains in the stock markets, an attracting option lies in investing funds outside of the home. In addition, having the extra liquidity of cash invested in stocks or bonds provides further support for this investment strategy. Finally, pertaining to the home mortgage interest tax deduction, is there any scenario where investing funds in home equity would be the optimal investment strategy?

The promise of higher investment returns additional liquidity and the home mortgage interest tax deduction provide significant motivation for making a minimum down payment on a home. However, when Private Mortgage Insurance premiums are considered, the minimum down-payment strategy becomes much less attractive.

About The Author 

Suvadip Das is a research fellow in management and at the same time a web developer. Web design is his passion. He has worked for  Freelance Writer Organization and various websites including www.super-mortgages.com.

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