Private mortgage insurance (PMI) is a common part of the homebuying process for borrowers who make a smaller down payment on a conventional mortgage. While PMI can increase your monthly mortgage payment, it may also allow you to purchase a home without waiting until you have saved 20% for a down payment.
Understanding how PMI works, what it costs, and when it can be removed can help you make a more informed decision when comparing mortgage options.
What is Private Mortgage Insurance (PMI)?
Private mortgage insurance, commonly called PMI, is insurance that protects the lender if a borrower stops making payments on a conventional mortgage.
PMI is generally required when a borrower makes a down payment of less than 20% of the home’s purchase price. It does not protect the borrower from foreclosure or cover the borrower’s mortgage payments.
According to the Consumer Financial Protection Bureau (CFPB), PMI may be required for a conventional loan when your down payment is less than 20% of the purchase price.
Why do lenders require PMI?
PMI exists primarily to protect lenders from the financial risk associated with higher loan-to-value mortgages.
A borrower who makes a 5% or 10% down payment has less equity in the property at the beginning of the loan than someone who makes a 20% down payment. PMI provides additional protection to the lender if the borrower defaults and the property does not generate enough proceeds to cover the outstanding mortgage balance.
For borrowers, the benefit is that PMI can make homeownership possible with a smaller down payment. In other words, PMI is an additional cost, but it can allow you to buy a home sooner rather than waiting to save a larger down payment.
How does PMI work?
When you make a smaller down payment, your mortgage represents a larger percentage of the home’s value. This creates more risk for the lender. PMI helps reduce that risk.
For example, suppose you purchase a $400,000 home with a 10% down payment:
- Home price: $400,000
- Down payment: $40,000
- Mortgage amount: $360,000
- Loan-to-value (LTV) ratio: 90%
Because the down payment is less than 20%, the lender may require PMI on the conventional mortgage.
The PMI premium is typically added to your monthly mortgage payment, although some mortgage programs may offer other ways to pay the premium. The exact cost depends on factors such as the loan amount, down payment, loan type, credit profile, and the mortgage insurance option available to you.
What is the difference between PMI and MIP?
PMI is generally associated with conventional mortgages, while MIP (Mortgage Insurance Premium) is associated with FHA loans. The requirements, costs, and rules for canceling or maintaining mortgage insurance can differ depending on the loan program.
When Can PMI Be Removed?
Once the homebuyer builds enough equity in the property – usually when the loan-to-value ratio drops to 80% or below – they can request the removal of PMI. This can be achieved through a combination of regular mortgage payments and appreciation in the home’s value.
For conventional mortgages, PMI may be canceled once you build sufficient equity in your home, subject to the requirements that apply to your loan.
There are several ways you may reach the point where PMI can be removed, including:
- Paying down your mortgage principal
- Making additional principal payments
- Building equity as the value of your home increases, depending on your lender’s requirements
- Reaching the applicable loan-to-value threshold
Because PMI cancellation rules can depend on the type of loan and circumstances surrounding the property, homeowners should contact their mortgage servicer to understand the specific requirements for their loan.
