Also known as "Primary Mortgage Insurance," PMI is the lenders' protection in the event that you default on your primary mortgage and the home goes into foreclosure.

When applying for a home loan, lenders typically require that a borrower provides a 20% down payment of the property's purchase price. If the borrower is unable to do so, lenders will typically look at the loan as a riskier investment and will require the borrower to take out PMI.

The PMI payment is usually paid monthly as part of the overall mortgage payment to the lender. Once the borrower has paid enough towards the principal amount of the loan (the equivalent of that 20% down payment), he or she can contact their lender and ask that the PMI payment is removed.

Another way to avoid the PMI payment is by taking out a smaller loan (typically at a higher interest rate) to cover the amount of the 20% down, as well as taking out the main mortgage, a practice commonly known as "piggybacking." Now the borrower is committed on two loans, but since the funds from the second loan are used to pay the 20% deposit, the borrower doesn't incur PMI. Borrowers can typically deduct the interest on both loans on their federal tax return if they are itemizing deductions.

A PMI may cost between 0.5% to 1% of the entire mortgage loan amount annually, and that can raise a mortgage payment by quite a bit. Example: Assuming you had a 1% PMI fee on a $200,000 loan, that fee would add up to approximately $2,000 a year, or $166 each month. A potential homebuyer might have to pay more, however, since according to Zillow the median listing price of U.S. homes is $275,000 as of December 2018. This may be a good reason to avoid taking out PMI, along with the fact that canceling PMI, once you have it, can be complicated. For many people, PMI is crucial to buying a home, especially for first-time owners who may not have saved up the necessary funds to cover a 20% down payment. Paying PMI could be worth it in the long run for buyers eager to have their own home.

The Bottom Line

PMI can be a costly necessity for home buyers who don't have enough money saved for a 20% down payment. It may be possible to avoid PMI by taking out a main mortgage plus a smaller loan to cover the costs of a 20% down payment, or reconsidering the purchase of a home without sufficient savings to cover the downpayment. A PMI can be removed once a borrower pays down enough of the loan's principal, and for first time home buyers, a PMI may be worth the extra money for the mortgage, and at tax time, borrowers can deduct it.