What Is Private Mortgage Insurance?

How Does Private Mortgage Insurance Work?

Lenders who issue conventional mortgages (home loans that aren't government-backed) typically want borrowers to put up 20% of the cost of the home as a cash down payment. In the world of financial institutions, this is expressed in an inverse way: Lenders prefer to issue loans for no more than 80% of the market value of the home. The percentage of the home's value represented by the amount of the loan is called loan-to-value (LTV) ratio:

On a $300,000 home, a borrower putting down 20% ($60,000) would require a loan of $240,000, yielding an LTV ratio of 80%. If a borrower put 15% down on the same home ($45,000), they would require a $255,000 loan—an LTV ratio of 85%.

Lenders seek 80% or lower LTV ratios as a precaution in case the borrower fails to repay the loan. Each mortgage loan is secured by the home itself, but if a borrower fails to pay and the lender is forced to take the home through foreclosure, there can be steep costs associated with re-selling it. Lenders can use down payments to help cover those expenses.

Coming up with a 20% down payment is difficult for many borrowers, especially those trying to enter the housing market for the first time. In light of this, lenders devised private mortgage insurance (PMI) as a way to issue mortgages with LTV ratios greater than 80%. When lenders issue loans with LTV ratios greater than 80%, they require you to purchase mortgage insurance to cover the difference between the amount you put down at closing and a 20% down payment.

In our hypothetical $300,000 home, if you made a 10% down payment (LTV = 90%), you'd need PMI coverage for $30,000, the amount of additional down payment you'd need for an LTV ratio of 80%.

When PMI is required, the lender secures a policy through one of the six companies currently offering mortgage insurance in the U.S. Borrowers have no vote in the choice of PMI provider, so there's no opportunity to compare pricing.

How Much Does PMI Cost?

The cost of PMI depends on the provider, the size and type of loan and, potentially, your debt-to-income (DTI) ratio. Premiums increase with the amount of coverage required, and PMI on adjustable-rate mortgages is more expensive than on fixed-rate mortgages.

PMI can cost as little as one-half point (0.5% of the total loan amount) to more than two points (2% of the total loan amount) per year. PMI payments can be structured in one of the following ways:

• Monthly: The most common PMI payment arrangement divides your annual PMI premium into 12 monthly payments, which are added to your monthly mortgage bill.
• Upfront: You pay for PMI in a lump sum as part of your closing costs. This lowers your monthly payments, but if you sell the home within a relatively short time, you could lose money on the deal, since the lump-sum payment is non-refundable.
• Split premiums: You purchase a portion of the PMI policy upfront and cover the rest in payments added to your monthly mortgage statements. This is fairly uncommon, but you can request it if you'd prefer to lower your monthly payments in exchange for higher closing costs.
• Lender-paid PMI: The lender covers the PMI premium, but shifts the cost to you in the form of higher interest rates. This is the least desirable form of PMI for the borrower, as there is no way to cancel it (or get rid of its cost) over the life of the loan. Lenders often insist on this arrangement when borrowers have poor credit.

What to Consider Before Choosing a Loan With PMI

Private mortgage insurance can be a great means of getting into a home without having to scrape together a full 20% down payment. If you're ready to own a home, you don't see a 20% down payment as a reality anytime in the near future, and you're willing to pay the cost of PMI to get into a home, it could be a good choice for you. But it's not an expense everyone chooses to take on.

First, it's an extra cost that adds to the price of owning a home. If you're already worried about ongoing loan payments and other homeownership costs, PMI could increase that stress.

If you want to avoid PMI, you can take the following actions:

• Seek government-insured loans issued by the Federal Housing Administration (FHA) or U.S. Department of Veteran's Affairs (VA). Each has significant borrowing restrictions, but if you qualify, you can avoid PMI.
• Save up until you have 20% of the purchase price to put down on a loan, recognizing that in some markets, housing prices will be rising as you save. So in another year (or another five years), the cost of homes like the one you seek will be proportionally greater, and so will the sum that constitutes 20% of their value.
• Use savings you already have as a down payment on a smaller loan. If you've saved enough, consider purchasing an older or smaller home in your area, looking around in other markets where housing costs are lower, or perhaps investigating condominiums or co-op apartment units. Getting into less home than you want right now might require some compromises, but it could also set the stage for trading up to a bigger property within the next five to 10 years.

How to Get Rid of PMI

Many borrowers are grateful when PMI helps them get a mortgage with an LTV ratio greater than 80%, but most are even more thankful when they can cancel their PMI coverage. Many loans call for automatic PMI removal after the date at which your monthly payments are calculated to get you past a 78% LTV ratio (in other words, when you've paid 22% of the home's "principal value"). But you can request PMI removal earlier if you can show your equity in the home equals or exceeds 20% of what you paid for the property (its "original value").

How long it takes to get to an 80% LTV ratio depends on several factors:

• The size of your down payment: The closer your original down payment was to 20%, the sooner you'll get to 80% LTV. For example, with all other factors being equal, for our hypothetical $300,000 home:

If you put down 10% on a 30-year loan at 4.5% interest, it would take just over six years to reach 20% equity. With a 5% down payment, it would take more than eight years. If you haven't saved 20% down payment for a home purchase, you may want to reconsider how much money you need to buy a home in order to avoid PMI payments.

• The size of your monthly payments: You can speed up accumulation of equity (and your arrival at 20% LTV) by "overpaying" your mortgage each month. In addition to enabling you to end PMI payments sooner, this practice can save you interest costs over the life of the loan. Prepaying your mortgage comes with some tradeoffs, however, so consider this option carefully before you proceed.
• Changes in appraised value: Your home's appraised value can change with market conditions. If you buy in an area with rising home prices, market appreciation on your property could help you get you to 20% equity even sooner. By contrast, declining neighborhood property values could prolong the time needed to reach 80% LTV.

Before PMI can be removed, you typically have to pay for a new appraisal (by an appraiser selected by the lender). Lenders require this to cover them in case the house's value has dropped below its original value. Appraisals typically cost a few hundred dollars, but prices can run up over $1,000 for very large homes or properties with unique or unusual features or amenities.

The new appraisal determines the value of the home that's used when calculating your LTV ratio. If you've reached 80%, you can eliminate your PMI. If you're not at 80%, you can try again anytime, but you may have to pay for another appraisal.

Can a Good Credit Score Help Me Avoid PMI?

If you have good credit, you could qualify for an 80/20 mortgage, which avoids PMI and gets you into a home for just the closing costs. You do this by taking out a mortgage for 80% of the property value, and a second loan for the 20% down payment. Both the 80% loan and the 20% loan are secured against the home, so defaulting on either one could result in foreclosure.

Lenders are highly selective about issuing 80/20 loans. In addition to a great credit history, you may be required to show a strong record of regular employment, meet minimum requirements for savings and other assets, and demonstrate that your outstanding debts total less than 45% of your income. These requirements put 80/20 loans out of reach for many borrowers, but if you qualify, it's an option worth investigating.

Many homebuyers see private mortgage insurance, and the hundreds of dollars per month it typically costs, as little more than a necessary evil. But by allowing homebuyers to purchase a home with a down payment of less than 20%, PMI lifts a major roadblock for many would-be homebuyers. It's a tool worth understanding, and it might help you get into the home of your dreams.