Banks can lower their risk of losing money on a home loan by maintaining a gap between the principal amount of the loan and the home’s value. With a typical conventional home loan (a loan made by a private bank without government backing), the amount won’t exceed 80% of the value of the home at the time the loan is made. This is called the loan-to-value ratio (LTV) and is intended to give the bank a 20% “cushion” should the value of the home drop after the loan is made or if the borrower stops making payments. The LTV guidelines are a combination of bank policies and guidelines from government housing agencies - they may vary somewhat but 80% is usual.
A downpayment of at least 20% in cash or from the sale proceeds of another home is the most common way this cushion is created. If a buyer doesn’t have access to those kinds of funds, private mortgage insurance (PMI) can come into play. The premium a buyer will pay for this coverage is usually 0.5-1.5% of the value of the loan and is collected and escrowed by the bank and tucked into the monthly mortgage payment. With the more comfortable level of risk provided by the PMI, the bank can proceed to make the loan.
Once there is enough equity in the home, the borrower can ask the bank to drop the PMI coverage. Banks do this at their discretion, usually after an appraisal. This can come about once enough paid principal has accumulated, the value of the home appreciates or the borrower makes enough of an advance payment that the LTV drops enough to justify eliminating PMI. Any combination of these factors (and some others) can lower the LTV. Many folks see PMI as less than ideal but it can be useful and necessary if there aren’t other options. If you have questions about PMI, loans or anything else real estate related, please reach out to one of us. And enjoy the fall!
