If you can't pull together enough cash to make a 20 percent downpayment on your nest, your lender may require you to buy private mortgage insurance. You can eventually eliminate this extra expense as you build up equity in your home. However, PMI is often unavoidable on a purchase mortgage even if you think that you have instant equity in the property.
What Is PMI?
If your mortgage goes into foreclosure, your lender can recover its losses by selling your house and applying the sale proceeds to your loan balance. The less equity you have in the home, the less chance your lender has to recoup its losses during the foreclosure sale. PMI is an insurance policy that protects lenders against such losses. Generally, you're required to buy PMI if you make a downpayment of less than 20 percent. The insurance firm covers your lender's losses up to 20 percent of the purchase price if the home goes into foreclosure.
When you find a home that meets your needs, you have to agree to a purchase price with the seller. Your lender orders an appraisal of the property after you sign the purchase contract. The appraisal may come back lower or higher than expected. If it's lower, you may have to renegotiate the purchase agreement because your loan amount can't exceed the home's actual value. If the appraisal is higher than expected, you can move forward with the loan. However, your lender may still require you to buy PMI if your downpayment is less than 20 percent because lenders base loan underwriting and PMI on the lesser of the purchase price and the appraised value.
A higher than expected appraisal can come to your aid when you're refinancing a loan. As with purchase mortgages, lenders usually require you to buy PMI if your refinance loan exceeds 80 percent of your home's value. Your lender preapproves your refinance loan on the basis of the information that you provide. If you underestimate the value of your home, your lender may include PMI in the equation. If the appraisal comes in higher than expected, you can normally ditch the PMI. Some homeowners with PMI on existing loans take advantage of price increases and refinance their mortgages specifically to get rid of PMI.
If you're required to buy PMI, your lender must automatically cancel the policy once you have built up 22 percent equity in your home. When calculating your equity the lender must go by the purchase price rather than your home's current market value. Worse still, if you fall behind on your payments, your lender may categorize you as a high-risk borrower. On high-risk loans, lenders can place stricter rules on your loan, including a delayed PMI removal.
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