What is private mortgage insurance (PMI)?

How does private mortgage insurance work?

Typically, when you think of insurance, you think of something beneficial to you in case of an emergency. However, PMI is not insurance that will protect you. It is enforced by the lender to protect the lender’s investment.

Despite the additional cost, PMI allows many individuals to become homeowners before they can afford the traditional 20% down payment. Once you have built up enough equity in your home, you can request to have the PMI removed, thereby reducing your monthly payments.

Advantages of PMI

“People generally view PMI as an added expense and try to avoid it. While that's typically good/conservative advice, putting down less than 20% and accepting PMI does have some benefits,” said Joe Salerno, the co-founder of Yardsworth, a Los Angeles-based company offering a home equity loan alternative.

“First, it might be the only way you can afford your home, and second, it does give you extra leverage. That means that if prices appreciate, you do even better.”

» MORE: Is buying a house a good investment?

How much does PMI cost?

The cost of PMI varies based on your loan-to-value ratio (LTV), the lender and your credit score, but it generally ranges from 0.5% to 1% of your entire loan amount per year.

For example, if you have a $400,000 loan and your PMI rate is 1%, you would pay $4,000 annually, or around $333 monthly.

How is PMI calculated?

Here's a simple way to calculate your PMI:

• Determine your LTV: This is calculated by dividing your loan amount by the appraised value of the property. For example, if you're buying a house worth $400,000 and put down 5%, or $20,000, you will need to borrow $380,000 and your LTV is 95%.
• Determine your PMI rate: This rate is set by your lender and depends on your LTV and your credit score. Let's say your PMI rate is 0.5%.
• Calculate your annual PMI cost: Multiply your loan amount by your PMI rate. In this case, $380,000 * 0.005 = $1,900.
• Calculate your monthly PMI cost: Divide your annual PMI cost by 12. So, $1,900 / 12 = $158.33 per month.

How to pay PMI

Most homebuyers will pay their PMI through monthly premiums that are added to their monthly mortgage bill. This is a manageable way to afford PMI without needing additional cash upfront at closing. Some other ways to pay PMI include:

• Upfront PMI, sometimes called single premium, requires you to pay all of your PMI as a lump sum at the time of closing.
• Lender-paid mortgage insurance, or LPMI, is sometimes an option available for buyers. The lender will cover the PMI costs in exchange for a higher interest rate. You will need to determine if your monthly costs are less with the PMI costs or the higher interest rate cost before choosing this option.
• Split premium allows you to choose a combination of the upfront and monthly options. Putting a large lump of cash toward your upfront PMI will decrease how much monthly PMI you will need to pay.

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How do I avoid paying PMI?

To avoid paying PMI from the start, you will need to put 20% down. If you cannot afford 20% down, there might be an option of searching for a lower-priced home or a fixer-upper that has a listing price way below its appraisal value.

Additionally, using gifted funds for a down payment can help you use finances from family, friends or an employer without tax consequences if it is under a certain amount.

Having to pay PMI is not the end of the world, and depending on the housing market, you might only have to pay this extra fee for an additional year or two. Here’s how to remove your current PMI:

• Reach 20% equity: The most common way to get rid of PMI is by building your home equity to at least 20%. You can do this by making regular payments on your mortgage, which will gradually reduce the principal balance. Once you've reached this milestone, you can request your lender to cancel the PMI.
• Automatic termination: According to the Homeowners Protection Act, your lender must automatically terminate PMI when your mortgage balance reaches 78% of the original purchase price, provided you are up to date with your payments.
• Refinancing: If your home's value has increased significantly, you may be able to refinance your mortgage. This could potentially give you a new loan with an LTV ratio of 80% or less, eliminating the need for PMI.

» MORE: How to get rid of PMI

Bottom line

While PMI can feel like an additional pesky cost when you are trying to finance the home of your dreams, it is not a fee that you will have for the life of your home loan. You will no longer have to pay PMI once you build up 20% equity in your home. It can also be worth paying PMI temporarily if it means getting into a home sooner.