PMI (Private Mortgage Insurance) is required when the down payment is less than 20% of the home's purchase price. This is an additional fee to your mortgage that you want to seek to avoid or if unavoidable, have a plan to get it removed as soon as you qualify to do so. The cost of PMI varies depending on factors such as the size of the down payment, the loan amount, and the borrower's credit score. The PMI premium is usually paid monthly as part of the mortgage payment, but it can also be paid as a lump sum upfront or as an annual premium.

It's important to note that PMI is not the same as homeowner's insurance. Homeowner's insurance protects the homeowner from damage to the property, while PMI protects the lender in case the borrower defaults on the loan.

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

Now let's talk about the cost of PMI. PMI can cost between 0.4% and 2.25% of the entire mortgage loan amount annually, which can raise a mortgage payment by quite a bit. For example, if 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.

Realize that PMI is designed to protect the lender, not the borrower. So, 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 does not have sufficient funds for a 20% down payment, they can avoid PMI by obtaining two loans - a smaller loan (usually at a higher interest rate) to cover the 20% down payment and the primary mortgage. This strategy is commonly referred to as piggybacking. Although this approach requires the borrower to be committed to two loans, PMI is not necessary because the funds from the second loan are utilized to pay the 20% deposit. Some borrowers can also deduct the interest on both loans on their federal tax returns if they itemize their deductions.

Another alternative to avoid PMI is to reconsider purchasing a home that requires a smaller down payment. Some lenders provide unique programs for first-time buyers with little or no down payment. However, it's important to note that government-backed loans, such as FHA loans, require a smaller down payment but also necessitate mortgage insurance, which is similar to PMI but known as MIP (Mortgage Insurance Premium).

One important thing to keep in mind is that PMI is not a permanent requirement. Once the equity in the home reaches 20% or more, the homeowner may be able to cancel their PMI. However, this process can vary depending on the lender and the loan agreement, so it's important to check with the lender about their specific requirements for canceling PMI.

Conclusion

Realize, PMI is a type of insurance that protects the lender in case the borrower defaults on their primary mortgage. PMI is required on a loan if the downpayment is below 20% of the gross sales price. Be aware you should request removal of the PMI and the mortgage company can remove it once the equity in the property reaches 20-22% on average or consider refinancing to a new mortgage loan at 20% without the PMI. PMI is not permanent and can be canceled once the equity in the home reaches 20% or more. Check with a financial advisor to decide what’s right for you.

PMI is an insurance policy that protects the lender in the event that you default on your primary mortgage and the home goes into foreclosure. It's typically required for borrowers who can't afford a 20% down payment on a home. PMI can be expensive, but it can also be a necessary cost for many first-time buyers. However, there are options to avoid paying PMI, such as piggybacking or taking out a smaller loan, or opting for a home with a smaller down payment, or looking for government-backed loans that have a smaller down payment requirement but also require a mortgage insurance.

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