How Does a Home Equity Loan Effect PMI?

Private mortgage insurance (PMI) protects mortgage lenders in the event of borrower default. You typically have to pay for PMI if you buy a home and make a down payment of less than 20 percent of the purchase price. You also need PMI if you refinance your home and the new mortgage exceeds 80 percent of your property value. However, you do not need to buy PMI if you have a home equity loan, because PMI only applies to loans in first lien position that are sold by your lender.

When you take out a mortgage, your lender usually continues to service your loan for the duration of the term, but servicing only involves processing your payments. The lender usually sells the actual mortgage debt to Freddie Mac or Fannie Mae, and your payments are passed from the servicer to whichever entity buys your debt. If you default on the loan, proceeds from the foreclosure sale go to the debt owner. If the mortgage holder receives less than 100 percent of your home's value during a foreclosure sale, the PMI covers the remaining balance.

Freddie Mac and Fannie Mae do not buy home equity loans from banks. Lenders typically do not sell equity loans and consequently rules pertaining to PMI do not impact home equity loans or lines of credit. Additionally, even if your lender does sell your equity loan to another lender, you do not have to pay PMI if your loan occupies the second lien position on your home. Lenders that do write home equity loans in first lien position normally cap loans at 80 percent of the property value, in which case you avoid PMI anyway.

Lenders that write home equity loans assume a higher degree of risk than first lien holders. If you default on your first or second mortgage and your home goes into foreclosure, the home sale proceeds go to the first lien holder. The PMI can make up a shortfall on the first lien but not the second, and if the home sells for less than the combined balances of the first and second lien, the equity lender may receive nothing after the foreclosure sale.

Because of the level of risk involved with home equity loans, lenders only allow people with above average credit scores to take out these loans. You typically need a credit score of at least 680 or 700 to qualify for a home equity loan, whereas lenders write first mortgages for people who have credit scores as low as 580. Additionally, you must have a low debt-to-income ratio, meaning your monthly debt payments should amount to no more than 35 or 40 percent of your total monthly income.