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Mortgage Fine Points


Private Mortgage Insurance (PMI)

Typically, a mortgage applicant needs to have a 20% down payment in order to buy a house. Banks tend to get nervous when potential buyers have less money than this to put down, because they worry that the buyers may default on the loan. Many people don't have 20% of the cost of the house they're considering, however. Private Mortgage Insurance (also called MIP for FHA loans) is a way for people to purchase a home without a full 20% down payment and still keep the bank happy.

PMI is insurance that will pay the lender in the event that you default on the loan. Because there is less risk for the lender, PMI allows you to purchase a home with a smaller down payment (3-5%). This sounds reasonable, but there is a downside. Although the lender receives payment in the event of default, the homeowner actually pays for the insurance, and the insurance is expensive!

It is best to avoid PMI altogether if that is possible. One way to do this when cash for a down payment is tight is to get a second mortgage to cover the missing part of the down payment (a non-conforming or 80/10/10 loan as described above). It is possible that a second mortgage will cost more than PMI, however, so be careful. You want to go with the cheaper of the two alternatives.

PMI can be removed, in most instances, once the homeowner has accumulated 20% or more of equity in the home. The Homeowner's Protection Act of 1998 makes it easier for homeowners to have PMI removed from their mortgage payments. This act mandates that lenders automatically remove PMI after a homeowner has established 22% equity in the home. There are some conditions for this to happen however. The homeowner must be current (up to date on payments) and considered low-risk. If a homeowner has made late payments or has other liens against the property, the lender does not have to remove the PMI.

Points/Buy Down

A buy down occurs when a home buyer pays the lender upfront in order to have the lender lower the interest rate on a mortgage. It will generally cost a home buyer 1% of the purchase price for each point. Each point is worth about 0.125% of interest on a 30 year mortgage. Although this seems like a very high price to pay for a seemingly insignificant change in interest rate, you have to remember the large amounts of money being borrowed and the length of the loan. A small change can have a dramatic effect over the life of a loan. Paying points at closing can be good for home buyers but only if they plan to keep the home for a long time. Because the initial cost is high and the change in interest rate is so small, a home buyer needs to plan on keeping the home 10-15 years or more (on a 30 year loan) on average to recoup the cost of the buy down. Most homeowners only stay in a house for 7 years or less, however. Seven years is not enough time to realize the benefits of paying points to buy down the mortgage rate. With this in mind, consider carefully before you offer to buy points on your mortgage.