Q: I just heard Ilyce on the radio talking to a listener about a house he was purchasing from his parents. She said that he would have to pay private mortgage insurance (PMI) if the appraisal came back and showed he was above the 20 percent equity threshold.
I just bought a foreclosure here in North Carolina and it appraised at $350,000 and I purchased it for $225,000. I didn’t have enough of a downpayment to cover the 20 percent required on the $225,000 for a conventional loan, so I was required to carry PMI even though it appraised above the threshold.
I was told by more than one lender that it was the purchase price only that determined PMI requirements. Was I mislead?
A: You weren’t misled, and the differing circumstances between the purchase between relatives and your situation can be explained.
If a parent is transferring title to a child, and there is no purchase agreement, the lender can only rely on an appraisal to determine the value of the property. However, in the situation where you are purchasing a home, the lender will rely on the lower of the appraisal or the contract purchase price.
Where there is a contract and an appraisal, the lender will look at the lower amount. The rational there is that a buyer knows best what the value of a property is if the appraisal happens to come in higher. And if the appraisal comes in lower, then the lender relies on that value. The lender will protect itself from lending too much money on a property by using the lower number.
As a borrower, you will be required to pay for PMI if the amount you borrow is more than 80 percent of the lower of the contract sale’s price and the appraised value of the home.
PMI is a type of insurance for the lender’s benefit and not for your benefit. The only benefit to a home buyer is that if you don’t pay for PMI, and you have less loan-to-value ratio greater than 80 percent, you won’t be able to get the loan.
In the good old days when property values were constant or increasing, lenders believed that they could only lend up to 80 percent of a property’s value to a borrower. If they lent more, the lender would take the risk that if they foreclosed on the property, there wouldn’t be enough money left over to pay the loan and the expenses unless they had that twenty percent cushion.
But borrowers wanted to buy homes and lenders wanted to lend money. So a system came about where lenders could lend more than 80 percent of a home’s value but a company would issue coverage to the lender that would cover the lender for any loss they might incur on the loan amount above that 80 percent threshold.
In other words, if a lender gives a homeowner a loan on 90 percent of the value of the home, the PMI company will pay the lender for any loss it sustains if it fails to get back money on that part of the loan that exceeds the 80 percent value threshold as of the day the loan was given.
The closer you get to a 100 percent loan-to-value ratio, the greater the risk of default. That’s why PMI gets more expensive the higher your loan-to-value ratio.
The good news for you is that after six months to a year, you may be able to approach a lender, refinance your loan and have the PMI removed. You won’t be able to do that with your current lender as you must have a two year track record before you can go to your lender and PMI company and request that they remove the mortgage insurance due to a higher appraisal.
When you are ready to refinance, talk to a mortgage lender or mortgage broker and make sure to go over your loan specifics with them as well as the valuation issue given your appraisal. Depending on the loan product you might want, you may or may not be able to refinance and get rid of the mortgage insurance.
As the mortgage rules change, lenders have different requirements for refinancing loans these days. You shouldn’t have to apply for a new loan to find out at that time whether the purchase price of your home will affect your appraisal on a refinance.
The mortgage broker should be able to tell guide you on how to deal with your situation given your recent purchase. You may find that a new appraiser will appraise your property at a value close to what you paid and you might be stuck paying PMI. But if the new appraiser’s value is similar to what the old appraiser came up with for your home, and you’ve had the loan for a sufficient period of time, you should be able to refinance, get rid of PMI and, if rates have gone down further, benefit from the lower rates.
If and when you refinance, please consider the closing costs, the interest rate and the length of the term of the new loan in determining whether the new loan is right for you.