One of a lender’s main jobs is to evaluate risk. If a lender looks at a loan application, what is the risk in making a home loan? How’s the credit look? Can the borrowers comfortably afford the new monthly payment? Is the property going to be owner-occupied or will it be a rental? How much down payment is involved? All of these questions and more must be answered before a final approval can be issued. Certainly having good credit is a positive as is affordability. Lenders also view rental properties as a higher risk than an owner-occupied home, thus the higher interest rate and additional down payment for a rental. But the down payment can carry considerable weight. The more down payment a borrower comes to the table with, the less risk for the lender.
It used to be that a minimum down payment could be 20 or 30% or more, depending upon the individual lender. Yet it’s obvious that kept a lot of folks out of a home, especially for first time buyers. Yet in the late 1950s, a private company came up with an insurance policy that addressed the hefty down payment issue. Instead of coming to the table with 20% or more for a down payment, a private mortgage insurance policy, or PMI was created. PMI allows consumers to buy and finance a home without a large down payment. Yet sometimes PMI gets a bad rap, as something to be avoided at all costs. That’s not the case. PMI isn’t a bad thing, it’s a good thing.
PMI is called a private mortgage insurance policy because the policy is applied toward a conventional loan. Government-backed mortgages, such as VA and FHA loans, also have forms of PMI but those can last through the life of the loan regardless of current market value.
A PMI policy is paid for by the borrowers but in the lender’s favor. Let’s say someone has a down payment of 5% plus some funds for closing costs. Instead of waiting and waiting until the savings account has the magical 20% down amount, the borrowers can put down 5% and take out a PMI policy. PMI pays the lender the difference between the down payment and 20%. Should the loan ever go into default, the lender is compensated for the 15% difference. Without PMI, the borrowers would have to sit on the sidelines for a while.
In addition, PMI isn’t a ‘forever’ thing. Most policies will automatically fall off when the loan balance reaches 78%-80% of the original value through natural amortization. That can take a while, most any amortization table will show that, but it will magically go away at that time. Further, borrowers can pay down a mortgage balance to reach the needed figure on their own. Borrowers can request the lender drop PMI due to an expected increase in property values. Or any combination of these. Again, unlike some government-backed loans, private mortgage insurance can go away at some point in the future.
Consumers should talk to their loan officer to get a thorough understanding of the impact of a down payment. But they should also be aware the PMI isn’t a bad thing. It’s a good thing and gets eligible borrowers in homes faster.