Many mortgage lenders use private mortgage insurance, or PMI, to mitigate their total exposure. The borrower pays the premium for this insurance. If the borrower defaults on a mortgage or equity loan, the PMI provider reimburses the lender for the principal amount borrowed. If you are thinking of taking out a home equity loan, it is important to understand the fundamentals of PMI and possible ways of avoiding this sometimes costly additional payment.
Basics of PMI
In traditional home finance, a lender provides the money to buy a home. Traditionally, borrowers were expected to make large down payments to have some equity in the house. However, lenders began to allow more flexibility for less-qualified borrowers. To reduce the risk of lending to homebuyers who were less than A-level credit, lenders now charge them for mortgage insurance. In general, if the mortgage balance exceeds 80 percent of the value of the house, you need to pay for PMI.
Home Equity Loans
If you want to avoid paying PMI, calculate your loan-to-value ratio. For example, if you have a first mortgage with a balance of $250,000 on a home worth .$350,000, your loan-to-value ratio is 71 percent, which is below the threshold where PMI payments would begin. However, if you need a $50,000 equity loan to complete a home project or to send your child to college, your loan-to-value ratio will increase to 86 percent. Your home-equity lender might ask for PMI payments, and so might your first mortgage lender
Before the housing crash of the last decade, some lenders used a backdoor to this mainstream 80 percent rule. This is a loan that "piggybacks" on top of a first mortgage loan. To avoid PMI payments, the consumer finances only 80 percent of his home's value in a first mortgage, then finances the remaining balance in a "piggyback" home equity loan. Although this might help you avoid PMI payments, the cost (fees and interest) of obtaining an equity loan, instead of a full refinance with PMI, can outweigh the benefits of avoiding PMI payments. This practice became too risky after the housing crash and lenders recommending it should be met with skepticism.
It's possible for your existing PMI monthly payments to be modified if you obtain a home equity loan. The cost of PMI is generally calculated as a percentage of your loan-to-value ratio. Lender calculations can vary, but in general, the further from the magic 80 percent loan-to-value figure you get, the higher your PMI premiums will be. Therefore, before taking a home equity loan, ask your first mortgage lender how much your PMI premiums would increase.
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