Save Thousands of Dollars by Knowing When You Can Cancel
The higher housing prices rise, the more difficult it is for first-time home buyers to come up with enough cash for both closing costs and the 20% down-payment most lenders require. PMI solves this problem for many home buyers.
What Is PMI and How Is It Calculated?
It would take the average couple more than five years to save enough for a 20% down payment on even a modest home, but thanks to PMI, home buyers can purchase a home years earlier by buying insurance that protects the lender. Private Mortgage Insurance (PMI), protects your lender if you default on your loan. It's calculated based on the amount you borrow for your house, and is rolled into your loan and added to your monthly payments. Remember: PMI protects the lender if you default on the loan; it does NOT protect you.
How Do I Know If I Still Need to Pay PMI?
Before the Homebuyers Protection Act was passed by Congress in 1998, lenders were not required to notify homeowners when the equity in their home reached a level where PMI was no longer required, so many homeowners continued to pay this cost unnecessarily for years.
Your home falls under this act if you purchased, constructed, or refinanced your single-family home after July 29, 1999, and your loan is not a government-insured FHA or VA loan. If you purchased your home before July 29, 1999, your lender is not required to cancel your PMI when you reach 20 or 22% equity, but many lenders will do so if you ask.
How and When Do I Cancel PMI?
If the act applies to you, your lender is required to automatically terminate your PMI when your equity reaches 22% of the original property value at the time you took out the loan.
For example, say you purchased a house valued at $100,000, paid $5,000 down, and financed $95,000. Your PMI would be cancelled when your equity reached $22,000, i.e., when the principal balance of your loan reached $78,000 (see calculation below). Alternatively, rather than waiting for your lender to cancel the PMI, you can request that it be cancelled when your equity reaches 20% of the original value of your home (as long as it hasn't decreased in value).
Paying PMI for even one month longer than necessary is throwing away your money. Know what your principal balance has to be in order to cancel your PMI, and obtain an amortization schedule of your loan (a schedule which shows how much of each monthly payment goes to principal and how much to interest and what the balance is after each payment) so you can see clearly when you reach that point. Don't wait for your lender to notify you that your PMI can be cancelled. It will cost you money as you wait for your equity to grow from 20% to 22%.
If you're not sure whether you are paying PMI, call your lender or the company that services your mortgage. If they inform you that you are paying PMI, ask for the details on when and how it can be cancelled. Don't pay a business to handle this for you--it's straightforward enough to do yourself.
One important note: in order for these protections to apply to you, your mortgage payments have been current for at least the last year, you cannot have any liens on your property, and your loan cannot be considered "high risk."
How Much Does PMI Cost?
On a $100,000 loan with a $5,000 down payment, PMI might cost you between $40 and $45 a month, or $480 a year. The cost on larger mortgages can be much greater. Cancelling as soon as possible can save you many thousands of dollars over the life of the loan.
Calculation: $100,000 value of the property at purchase or refinance times 78% (100% minus 22% equity required) = $78,000 loan balance or lower required before PMI will automatically be cancelled.
What is an Adjustable Rate Mortgage (ARM)?
An ARM is a mortgage with an interest rate that is linked to an economic index. The interest rate--and your payments--are periodically adjusted up or down as the index fluctuates.
You'll hear the following terminology when talking with lenders about ARMs.
An index is what the lender uses to measure interest rate changes. Common indexes used by lenders include one, three, and five-year Treasury securities, but there are many others. Each ARM is linked to a specific index.
Think of the margin as the lender's markup. It is an interest rate that represents their cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of the loan.
The adjustment period is the period between rate adjustments.
You may see an ARM described with figures such as 1-1, 3-1, and 5-1. The first figure in each set refers to the initial period of the loan, during which your interest rate will be the same as it was on the day of closing. The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments.
If my payments can go up, why should I consider an ARM?
The initial interest rate for an ARM is lower than that of a fixed rate mortgage (where the interest rate remains the same during the life of the loan). A lower rate means lower payments, which might help you qualify for a larger loan.
Other reasons to consider an ARM:
- The possibility of higher rates isn't as much of a factor if you plan to be in the home for a relatively short time.
- Do you expect your income to increase? If so, the extra funds may cover the higher payments that result from rate increases.
- Some ARMs can be converted to a fixed-rate mortgage. However, conversion fees may be high enough to take away all of the savings you saw with the initial lower rate.
- While you normally can't dictate which index a lender uses, you can choose a lender based on which index will apply to your loan. Ask how each index has performed in the past. Your goal is to find one that has remained fairly stable in economic downturns.
- When comparing lenders, consider both the index and the margin rate being offered.
- If the lender doesn't plan to sell your loan on the secondary market, you might be able to avoid the Private Mortgage Insurance (PMI) that's normally required when a buyer makes less than a 20% downpayment.
Consider the following before accepting an ARM
Discounted Rates - Buydowns
A lender may offer you an initial rate that's lower than the sum of the index and the margin. This sometimes happens when the seller pays a fee that compensates for the reduced rate.
Interest Rate Caps
- The Double Whammy
Your payments can rise significantly if your rate is adjusted upwards at the same time the discount expires.
- Is it Worthwhile?
Sellers may raise the price of a home by the amount they pay to buydown your loan. The extra cost may in time override any savings from the initial discount.
Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.
- Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.
- Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.
A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps.
If an interest rate cap has held your interest down even though the index went up, the amount of the increase can be carried over to the next adjustment period.
Amortization takes place when payments are large enough to pay the interest due plus a portion of the principle.
Negative amortization occurs when payments do not cover the cost of interest. The unpaid amount is added back to the loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the loan. Negative amortization generally occurs when a loan has a payment cap that keeps monthly payments from covering the cost of interest.
Negative amortization does not have as much of an impact when real estate is appreciating nicely, so the lower payments may be more attractive to you than paying down the principle.
The Bottom Line
Lenders are required to give you written information to help you compare and select a mortgage. Don't hesitate to ask as many questions as it takes to help you understand every aspect of your loan.