When you apply for a mortgage, the lender will typically require a down payment equal to 20% of the home's purchase price. If a borrower can't afford that amount, a lender will likely look at the loan as a riskier investment and require that the homebuyer take out PMI, also known as private mortgage insurance, as part of getting a mortgage.
PMI protects the lender in the event that you default on your primary mortgage and the home goes into foreclosure.
- Lenders require borrowers to pay PMI when they can't come up with a 20% down payment on a home.
- PMI costs between 0.5% and 1% of the mortgage annually and is usually included in the monthly payment.
- PMI can be removed once a borrower pays down enough of the mortgage's principal.
- A homebuyer may be able to avoid PMI by piggybacking a smaller loan to cover the down payment on top of the primary mortgage.
How PMI Works
One of the measures of risk that lenders use in underwriting a mortgage is the loan's loan-to-value (LTV) ratio. LTV divides the amount of the loan by the value of the home. Most mortgages with an LTV ratio greater than 80% require that the borrower have PMI as they are considered more likely to default on a loan.
PMI is usually paid monthly as part of the overall mortgage payment to the lender, but sometimes it is paid as a one-time up-front premium at closing. PMI isn't permanent—it can be dropped once a borrower pays down enough of the mortgage's principal. 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 can 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.
This cost may be a good reason to avoid taking out PMI, along with the fact that canceling, once you have it, can be complicated. However, for many people PMI is crucial to buying a home, especially for first-time buyers 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 own their own home.
Since PMI is designed to protect the lender, if you fall behind on your payments it will not protect you, the borrower, and you can lose your home through foreclosure.
How to Avoid Paying 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. Some borrowers can deduct the interest on both loans on their federal tax returns if they itemize their deductions.
Another option to avoid PMI is to reconsider the purchase of a home for which you have insufficient savings to cover a 20% down payment and instead look for one 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 homebuyers, 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 through 2020).