Summary: PMI protects the lender in the event that you default on your primary mortgage and the home goes into foreclosure.
When you apply for a conventional loan, 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 consider the loan as a riskier investment and require the homebuyer take out private mortgage insurance (PMI) as part of obtaining a mortgage.
How does PMI work?
PMI is usually paid as part of the monthly mortgage payment to the lender. PMI isn’t required for the life of the loan. Instead, 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 (when the equity reaches 22%). Alternatively, a borrower who has paid the equivalent of that 20% down payment can contact their lender and request that the PMI payment be removed.
It is important to understand that PMI doesn’t protect the borrower from foreclosure if they get behind on payments. It is solely for offsetting the lender’s risk by loaning more than 80% of the original value of the home.
How much does PMI cost?
PMI can cost between 0.5% and 1% of the entire mortgage loan amount annually. This can raise a mortgage payment quite a bit and therefore may have a negative impact on a family’s monthly budget.
For example, for a 1% PMI fee on a $200,000 loan, the fee would add approximately $2,000 a year, or $166 each month, to the cost of your mortgage.
What are alternatives to PMI if you have less than 20% down?
Piggybacking is a term assigned to taking two loans to avoid PMI. The first loan is smaller and covers the 20% down payment, while the second loan is for the mortgage. This smaller loan typically has a higher interest rate and may come with a balloon payment that is due at a specific time after closing.
Otherwise, it may be more prudent to seek out a home with a lower purchase price that enables you to put the required 20% down. Alternatively, waiting until savings are sufficient enough to pay the 20% down payment will help to avoid PMI.