Private Mortgage Insurance (PMI) Explained

If you have a mortgage or are shopping for one, you’ve probably seen mentions of private mortgage insurance, more commonly known as “PMI.” It is required on certain types of mortgages, but not on others.

This pesky expense is best avoided, but that isn’t an option for every new homebuyer. If you’re paying for private mortgage insurance, don’t worry, there is still hope that you can get rid of it early.

When you get a mortgage, the lender is taking a risk by giving you a large amount of money. They minimize this risk by technically owning a portion of your house until you pay off the entire mortgage loan. If you stop paying, they’ll take the house back, sell it, and get back some of the money they lent you. “Some” is a big word though — the bank still ends up losing money if they foreclose.

That’s where PMI comes in. If the bank thinks you are more likely to default — that is, to stop making your mortgage payments — they will make you buy PMI.

PMI is insurance for the bank, not for you. If you default and they foreclose on your house at a loss, the PMI will help them cover this loss.

Again, PMI only benefits the mortgage lender. There are no benefits for the buyer, aside from the fact that it allows you to buy a house while putting less money down.

How is PMI Different from Homeowners Insurance?

PMI is not to be confused with homeowners insurance, which is also required by mortgage lenders. Homeowners insurance pays you for damage or complete destruction of the physical structure of the home.

When is PMI Required?

As a general rule, PMI is required anytime a homebuyer either purchases a home with a down payment of less than 20% of the purchase price, or refinances the home with a new mortgage that exceeds 80% of the property’s appraised value.

In each case, the mortgage servicer is looking to make sure that the borrower has a personal stake of at least 20% of the property value.

Let’s say you buy a house and make a small down payment of 5%. This means, in the beginning, you only really own 5% of the home. This makes banks nervous. They’ve been studying borrowers’ habits for a long time and they’ve come to the conclusion that the more of a home the buyer has a stake in, the less likely they are to default.

When a homeowner has already paid for at least 20% of a property, it is considered unlikely that he or she will walk away from the property and not pay the mortgage — they simply have too much skin in the game.

Does the Lender take on Any Risk if You have PMI?

Making you pay for PMI does not mean the lender has zero risk on a loan. This is because PMI does not insure the entire amount of the mortgage, but only a percentage of it.

If you only put down 5% on a property, you may have to pay for PMI that covers 30% of the mortgage.

The actual cost of PMI to you as a mortgager will vary based on the following factors:

• The term of the mortgage (in years).
• The type of loan: fixed rate, or adjustable rate mortgage (ARM).
• The “loan-to-value” or LTV. This is the amount of the mortgage divided by the value of the property. The further this exceeds 80%, the higher the PMI premium rate will be.
• Your credit score.
• The level of PMI coverage required by the lender, under the specific loan program.

PMI is calculated based on the outstanding balance of your loan. This means that as the principal balance of your loan declines, your monthly PMI payment will fall as well.

Already have PMI and want to get rid of it? Caton Del Rosario breaks it down here:

There are basically five ways to eliminate PMI once you have it as part of your mortgage:

1. Request PMI cancellation when the amount of your mortgage falls to 80% or less of the original purchase price. You must be current on your payments and have a good monthly mortgage payment history, have no second liens on the property, and may be required to provide certification (usually an appraisal) confirming that the value has not declined since the property was purchased.
2. Let automatic PMI termination kick in. Your lender is required by law to cancel your PMI coverage on the date when your principal balance falls to 78% of the original value of your home. Alternatively, the PMI is required to be canceled at the halfway point of your mortgage term (15 years into a 30 year loan, as an example)
3. Refinance the existing mortgage at a time when you have at least 20% equity in your home.
4. Request an appraisal if you believe your home’s value has appreciated since you purchased it, and your equity has therefore increased to 20% or more. Some lenders will allow you the more affordable option of paying for a Broker Price Opinion (BPO) instead of a costly appraisal.
5. Sell your home and pay off the mortgage.

Lastly, there is one more way to get rid of PMI early: Make additional principal payments. This will increase your financial stake in the property and you’ll hit that 20% mark sooner.

For those with an FHA loan, PMI can not be removed. In this case, you will have to refinance the home to remove the PMI.

PMI is best avoided altogether, if possible. How can you do that?

The most obvious answer is to make a 20% down payment on your home. That may mean delaying the purchase of the home until you have 20% saved, or going to your family for help.

Still, another method to avoid PMI — one that’s not as easy to accomplish as it once was — is to do a first/second combination mortgage.

In this arrangement, you take a first mortgage equal to 80% of the purchase price of the property. That eliminates the need for PMI on the first mortgage. You then take a second mortgage or a home equity line of credit (HELOC) for up to 15% of the purchase price, and put down 5% of your own funds.

You can even do an 80-20 combination and avoid both the down payment and the PMI requirement. However, this type of combination is only available for very strong borrowers with outstanding credit. And having zero equity in your home does increase the likelihood of losing the property in foreclosure, so approach this method carefully.

Homeownership is already expensive enough without the additional financial burden of paying for private mortgage insurance.

You can get rid of PMI by making extra principal payments so that you reach 20% equity in your home early; or better yet, you can avoid it from the get-go by waiting to buy a property until you can make a down payment of at least 20%.