PMI, also known as private mortgage insurance, is a lender's protection in the event that you default on your primary mortgage and the home goes into foreclosure.

When borrowers apply for a home loan, lenders typically require a down payment equal to 20% of a property's purchase price. If a borrower is unable to afford that amount, a lender will typically look at the loan as a riskier investment and require that the borrower take out PMI.

One reason to avoid PMI is that once you have it, it can be complicated to cancel.

The PMI is usually paid monthly as part of the overall mortgage payment to the lender. Provided a borrower is current on their payments, their lender must terminate PMI on the date the loan balance is scheduled to reach 78% of the original value of the home (in other words, when the equity reaches 22%). Alternatively, a borrower who has paid enough towards the principal amount of the loan (the equivalent of that 20% down payment) can contact their lender and request that the PMI payment be removed.

The Cost of PMI

PMI may cost between 0.5% and 1% of the entire mortgage loan amount annually, which can raise a mortgage payment by quite a bit. Let's say, for example, that you had a 1% PMI fee on a $200,000 loan. That fee would add approximately $2,000 a year, or $166 each month, to the cost of your mortgage. And a potential homebuyer might have to even pay more since, according to Zillow, the median listing price of U.S. homes was $275,000 as of December 2018.

Key Takeaways

  • Lenders require borrowers to pay PMI or private mortgage insurance when they cannot make a down payment on a new home equal to 20% of the property's purchase price.
  • PMI may cost between 0.5% and 1% of the entire loan amount annually and is usually included in the borrower's monthly mortgage payment.
  • A homebuyer may be able to avoid PMI payments by piggybacking a smaller loan to cover the down payment on top of the primary mortgage, or by choosing to purchase a less costly home.

This cost may be a good reason to avoid taking out PMI, along with the fact that canceling PMI, once you have it, can be complicated. However, 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 for this insurance could be worth it in the long run for buyers eager to have their own home.

How to Avoid PMI

If a homebuyer doesn't have the funds for a 20% down payment, it's possible to avoid PMI by taking out two loans—a smaller loan (typically at a higher interest rate) to cover the amount of the 20% down, plus the main mortgage. This practice is commonly known as piggybacking. Although the borrower is committed on two loans, PMI is not required since the funds from the second loan are used to pay the 20% deposit. Borrowers can typically deduct the interest on both loans on their federal tax returns if they itemize their deductions.

Another option is to reconsider the purchase of a home for which you have insufficient savings to cover the down payment and instead look for a home that fits your budget.

The Bottom Line

PMI can be a costly necessity for homebuyers who don't have enough money saved for a 20% down payment. It may be possible to avoid PMI by taking out the main mortgage plus a smaller loan to cover the costs of a 20% down payment. However, for first time home buyers, PMI may be worth the extra money for the mortgage—and at tax time, many borrowers can deduct it (there are income limitations and the deduction isn't permanent, though it was renewed for 2018 taxes). PMI can be removed once a borrower pays down enough of the mortgage's principal.