When you have student loans, car payments and a whole stack of other expenses to contend with, saving up 20 percent for a down payment on a home can prove difficult. Fortunately, some lenders offer up to 96.5 percent financing on homes, but low down payment mortgages come with a cost known as private mortgage insurance. While PMI protects the interests of lenders, federal laws exist that limit the ability of finance firms to charge you for this insurance.
Historically, lenders only allowed homeowners to finance up to 80 percent of the property value of a home. The homeowner's 20 percent equity gave lenders some breathing room to cover legal costs or home depreciation in the event of a foreclosure. PMI acts as a substitute for home equity. You pay a monthly or annual fee to an insurance firm to guarantee the portion of your loan that exceeds 80 percent of the property value. If you renege on the debt, your lender can sell your home at auction, then file a claim with the insurer if the foreclosure sale fails to raise enough money to cover the past-due balance.
In the past, some lenders required homeowners to pay for PMI for the duration of the loan term. Consequently, Congress passed the Homeowners Protection Act of 1998, which requires lenders to automatically drop PMI once you have built up 22 percent equity in your home. Your lender must calculate your equity by using the lower of the appraised value of your home when you bought it or the actual purchase price. Cancellations of PMI at 22 percent equity are automatic, but homeowners can also request to have PMI canceled once they have built up 20 percent equity.
While not a private company, the Federal Housing Administration guarantees loans in much the same way as insurance companies. However, FHA loans are excluded from laws pertaining to the cancellation of PMI. Your lender may allow you to cancel PMI when you have built up equity, but in theory a lender could require you to keep paying FHA premiums for the duration of the loan. Likewise, loans insured by the Department of Veterans Affairs are also exempt from PMI cancellation rules.
Under the HPA, lenders can require you to keep PMI in place if you have a high-risk loan; government-sponsored Freddie Mac and Fannie Mae are responsible for issuing guidelines for definitions of high-risk. Generally, high dollar or jumbo loans exceeding $417,000 are classified as high-risk. Additionally, the HPA only covers loans issued after July 28, 1999. If you have a loan or assume a loan that pre-dates the HPA your lender may or may not allow you to drop PMI. While federal laws on PMI cancellation are somewhat limited, some states have laws that enable homeowners to cancel the insurance in various other situations.