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With most loans exceeding six figures, the bank will demand assurance that they will get paid even if the borrower defaults and that's where private mortgage insurance (PMI) comes in. PMI is an insurance policy that protects the lender from loss by covering the cost of foreclosing on a property in the event the borrower defaults on the mortgage. PMI insurance is similar to other forms of insurance like car insurance. Although PMI protects the bank, the monthly premium is paid by the homeowner. Private mortgage insurance is required for any loan that is more than 80% of the purchase price. Homeowners who make a down payment of 20% or more will generally not be required to pay PMI.
Private mortgage insurance benefits both the homeowner and the lender. For the lender, they are more willing to offer a loan to a potential homeowner because they can be assured of being covered in case of a default. For homeowners, they are not required to have a 20% down payment in order to purchase a home. Homeowners can purchase a property with as little as a 3% down payment. PMI encourages banks to make more loans and it allows people to buy into the American dream.
In 1998 Congress passed the Homeowners Protection Act. This act covered loans that originated after July 29, 1999. Lenders are required to disclose to borrowers the costs associated with PMI and the requirements needed to cancel the insurance. Costs for PMI are contained in 2 parts: initial payment made at closing and the monthly payment that is included in your mortgage payment.
It is possible to cancel the PMI insurance on your loan which will lower your monthly payment. The requirements for cancelling PMI will be outlined in your loan documents. For loans that originated after July 29, 1999, PMI may be canceled when you have at least 20% equity in your home. For loans prior to that date, the guidelines for canceling will depend on the lender and there is no guarantee that they will cancel the insurance. Before canceling PMI, most lenders will require that the homeowners not have any additional mortgages on the property such as a second mortgage or home equity loan.
Equity is determined by the current market value of your house. This value may be more or less than your original purchase price. Market value is determined by an appraisal performed by a certified appraiser. If the outstanding balance of your mortgage is 80% or less of the appraised value, you can request the bank to cancel your PMI.
The Homeowners Protection Act provides guidelines in which lenders are required to automatically cancel PMI. The requirement is the homeowner has paid down the loan to 78% of the original loan amount. Once this threshold is met, the lender will cancel PMI if the homeowner is current on their mortgage payments. Regardless of whether or not the above conditions are met, the lender is required to automatically cancel PMI at the midpoint of the loan term.
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