Paying private mortgage insurance up front
Home buyers are always hoping for an affordable transaction, both in terms of the down payment and monthly payments on a mortgage. Unfortunately, private mortgage insurance is often an inevitable part of a home purchase.
This extra cost is applied when a buyer puts down less than 20 percent of the purchase price. Lenders consider that mortgages with loan-to-value ratios higher than 80 percent are riskier, since the buyer has less equity in the property. If the home's value drops, the buyer can be left with an outstanding loan amount higher than their property is worth. Private mortgage insurance helps protect the lender if the borrower defaults on an underwater loan.
Many buyers won't have enough money to make a down payment of 20 percent, forcing them to assume private mortgage insurance costs as part of their monthly payment. However, there is also an option to pay this expense up front to eliminate it from the mortgage payments.
Prepayment of these costs is known as single premium private mortgage insurance. Michele Lerner, writing for the National Association of Realtors, says this arrangement typically allows you to pay 1 to 2 percent of the loan toward private mortgage insurance.
One of the biggest benefits of paying private mortgage insurance up front is the ability to borrow more money to buy a home. Poonkulali Thangavelu, writing for the financial site Bankrate, says avoiding private mortgage interest on your monthly payments allows you to lower your debt-to-income ratio. This in turn will allow you to qualify for a larger mortgage.
The lender usually provides some incentives for buyers who wish to use single premium private mortgage insurance. Glenn Curtis, writing for the financial site Investopedia, says lenders might also offer a discount for lump sum payments toward private mortgage insurance.
In another type of single premium private mortgage insurance, the lender pays the upfront cost and the borrower pays it back through a higher interest rate. Lisa Prevost, writing for the New York Times, says your payments will still be lower even if more of the payment is going toward interest each month. Fannie Mae says this can also allow you to get the maximum tax benefits, since the interest will be deductible. However, you'll also have to pay the higher interest rate for the life of the loan.
There are certain disadvantages to paying private mortgage insurance up front. The initial cost will typically require you to put up thousands of dollars, which is often a challenge for buyers who can't make a large down payment. Thangavelu says you may be able to get the seller to cover this cost as a closing concession, or use a monetary gift from a friend or family member for this purpose.
Paying private mortgage insurance up front will only be beneficial if you plan to stay in the home for at least two or three years. At this point, the savings on your monthly payments will reach a break-even point with the money you put toward the interest. If you end up leaving the home before then, you won't recoup these funds.
The market can sometimes help eliminate private mortgage interest faster than a lump sum payment. While private mortgage insurance expenses will automatically cease once the lender determines that you've built up at least 20 percent equity in the property, you can also request an appraisal to end these payments early if you believe your property value has increased enough for you to reach this share early.
Even if you pay your private mortgage insurance up front, you can still apply for a refund if you reach the 20 percent equity mark ahead of schedule. But it's easier to put this consideration aside if you make a lump sum payment. Tara-Nicholle Nelson, writing for the real estate site Inman News, says paying the private mortgage insurance up front might make you less vigilant about keeping track of your home value, which in turn makes you less likely to ask the lender to end this expense.
Not every lender will offer single premium private mortgage insurance. Scott Sheldon, writing for Credit.com, says you'll want to ask about the option when looking at different lenders. Thangavelu says the option won't be available for certain mortgages, such as FHA and USDA loans.
Buyers who want to avoid private mortgage insurance payments each month when making a lower down payment can explore some other options as well. Fannie Mae says you might be able to pay some of the expense up front and finance the rest through monthly payments. Other possibilities include annual lump sum payments toward private mortgage insurance or having the expenses rolled into your loan amount and amortized over 30 years.