To encourage home buying during the Great Depression, the government created the Federal Housing Administration to provide insurance to banks on FHA-approved loans. If the borrower defaults, the bank is repaid in full and the home is taken over by HUD, the Department of Housing and Urban Development for sale.
FHA-insured loans are known as conforming loans, with loan limits of $417,000, or up to $625,500 in high-cost areas, and $938,250 in Alaska, Guam, Hawaii and the Virgin Islands. They have their own requirements including income verification, credit scores, and work history. FHA loans are desirable because borrowers can finance up to 97% of the purchase price of the home, and there are ceilings on the interest rates that can be charged by banks.
A solution for non-conforming borrowers
But not every borrower meets FHA guidelines, particularly those who want to finance a larger,
more expensive home, or unique homes that are more difficult to appraise.
To serve these borrowers, lenders increasingly turned to non-government-insured loans.
Conventional loans are bank loans that are intended for purchase by the secondary market dominated by Fannie Mae and Freddie Mac. Conventional loan limits are larger and there is no interest rate cap, but their higher risk requires a bigger down payment from borrowers, usually 20% of the purchase amount. The loans are purchased by the secondary market and packaged into securities, allowing the banks to borrow fresh money for lending by the Federal Reserve.
Many otherwise qualified borrowers were not able to qualify for these loans because they didn’t have enough to meet the down payment requirements. Private mortgage insurance (PMI) allows these borrowers to purchase a home with less down, with PMI insuring the difference.
PMI is paid to the lender at closing by a private mortgage insurance company. The borrower pays back the PMI, along with principal and interest payments.
For example, a borrower could put 10% down, and obtain a conventional 80% mortgage with PMI paying the remaining 10%.
What’s confusing to borrowers is that many believe the PMI should be eliminated from their loan obligations after they build equity of 20% or more, but that’s a misconception.
Loans purchased by Fannie Mae and Freddie Mac also have guidelines, and require 30% insurance coverage if the borrower puts 5% down, 25% coverage with 10% down and 12% coverage with 15% down. The extra insurance is not only designed to cover the amount defaulted, but additional costs such as unpaid interest, legal expenses and property preservation expenses.
To have PMI eliminated, borrowers must have good mortgage repayment history as well as proof of the home’s current value, which can be determined by a professional appraiser at a cost of approximately $375-$500. The equity in the home must have improved so that the loan-to-value ratio is 75% or less.
Borrowers may also provide a written request for cancellation of PMI if the principal balance is paid down to 80% of the loan’s original amount if the PMI is borrower-paid. Federal law also requires mortgage insurance to be canceled automatically when the borrower has paid down their mortgage loan to 78% of the original loan amount.