Private Mortgage Insurance: How PMI Works and When It Makes Sense

For some people, buying a home is the ultimate financial goal. Homeownership is an opportunity to earn equity, put down roots, and it can provide a sense of accomplishment.

But even if you can afford a monthly mortgage payment and have good credit, a down payment is often the biggest obstacle to buying a property.

In the past, 20 percent was a traditional down payment amount. The good news is that lenders don’t require this today.

Yet, some people still believe that they need this amount to qualify for a mortgage. 

The truth is:

You can buy a house with as little as 3 percent to 5 percent down.

But if you buy a home with less than a 20 percent down payment, you might be required to pay private mortgage insurance.

What Is Private Mortgage Insurance?

When paying back a mortgage loan, monthly payments include repayment of principal and interest.

It also includes homeowner’s insurance, taxes, and sometimes private mortgage insurance. 

Private mortgage insurance, or simply PMI, is an added expense that’s common with conventional mortgage loans.

You’re often required to pay PMI if you purchase a home with less than a 20 percent down payment. Although you’re responsible for this expense as the borrower, private mortgage insurance protects your mortgage lender. 

Typically, the smaller a borrower’s down payment, the greater the risk of default. But when borrowers put down a larger down payment — or have more skin in the game — the likelihood of default decreases.

PMI protects your lender from large losses in the event of default, or if you stop making the mortgage payment.

Private mortgage insurance is a term used specifically for conventional home loans.

But other loan programs have their own version of this insurance. There’s mortgage insurance with an FHA home loan and a USDA home loan. VA home loans, however, don’t require mortgage insurance.

Cost

The cost of private mortgage insurance varies, but ranges from 0.5 percent to 1 percent of the loan amount.

On the high end, if you receive a $200,000 loan with a 1 percent annual PMI fee, you might pay an extra $2,000 a year, or an extra $166 a month.

How Does Private Mortgage Insurance Work?

Mortgage lenders include private mortgage insurance with the mortgage payment, so you don’t have to make a separate insurance payment every month.

Understand, though, paying PMI does increase your overall housing expense.

The good news is that private mortgage insurance isn’t a permanent expense.

Since you’re only required to pay this insurance when you put down less than 20 percent, your mortgage lender will remove this insurance once you have enough equity.

When PMI drops

PMI automatically drops once you have 22 percent equity, at which point your mortgage payment will decrease.

But, you don’t have to wait for your lender to waive this expense. You can request its removal once your property has 20 percent equity.

This only applies for conventional loans backed by Fannie Mae and Freddie Mac. These are two of the largest purchasers of mortgages on the secondary market.

Mortgage insurance rules differ with an FHA and a USDA home loan.

In both cases, mortgage insurance is usually for life.

The only exception is if you get an FHA home loan with at least a 10 percent down payment. In this case, your lender can drop mortgage insurance after 11 years.

Do I Need Private Mortgage Insurance?

Buying a home with at least a 20 percent down payment has its benefits.

You’ll have instant equity, and a larger down payment reduces your monthly payment. Plus, the bigger the down payment, the easier it is to negotiate a better mortgage rate.

Yet, it can take years to save a 20 percent down payment, even if you save aggressively. For a $200,000 home purchase, 20 percent would be $40,000 — and this doesn’t include closing costs. 

As a borrower, you’re also responsible for this expense, which can be another 2 percent to 5 percent.

If you’re ready to buy a house, and you have at least 3 percent to 5 percent, putting down less money and paying PMI allows you to buy sooner rather than later. The longer you wait to buy, the greater the risk of home prices and mortgage rates increasing.

But what if you’re in a position to put down 20 percent, or close to this amount? Should you? 

Ideally, you should never completely empty your savings account for a home purchase.

So if putting down a larger down payment will deplete your cash reserve, it’s a wiser move to put down less and keep some of your money for emergencies.

Tips

Since private mortgage insurance is an added expense, getting rid of it can save you thousands. Here are a few ways to avoid this housing cost.

1. Make extra principal payments

The sooner you earn enough equity, the sooner your mortgage lender will waive or drop PMI. 

You’ll gradually earn equity as your property appreciates in value and you pay down the mortgage balance. You can speed the process, though, by making extra principal payments. 

For example, make one extra principal-only payment a year, or add a little bit to each monthly payment to start chipping away at your balance. This will build equity faster and remove mortgage insurance sooner.

2. Refinance an FHA or USDA home loan

Paying mortgage insurance for life with an FHA or USDA home loan is expensive.

An extra $100 a month adds up to an extra $1,200 a year, or an extra $36,000 over the life of your mortgage.

So, consider refinancing your mortgage once you have at least 20 percent equity.

Refinancing is the process of getting a new mortgage loan to replace your existing loan. You’ll have to reapply for the loan, have your credit check, submit supporting documentation, and go through the closing process again. This includes paying closing costs again.

The upside:

Refinancing can eliminate mortgage insurance and help you save money in the long run.

3. Make a bigger down payment

If you can’t afford a 20 percent down payment, maybe you can afford a little less, say 10 percent. 

The annual cost of private mortgage insurance isn’t a set percentage.

Rather, it varies from borrower to borrower.

The bigger the down payment, the less you’ll pay for mortgage insurance.

Somebody with a 3 percent down payment might pay 1 percent of the loan balance annually. A borrower with a 10 percent down payment, though, might only pay 0.5 percent of the loan balance annually.

4. Get a piggyback mortgage

A piggyback mortgage is another way to avoid private mortgage insurance. A common option is the 80/10/10 loan. 

Basically, you get a first mortgage to cover 80 percent of the home price, a second mortgage to cover 10 percent of the down payment, and then you put down 10 percent of your own money. 

Keep in mind:

The second loan to cover your down payment, or the piggyback loan, often has a higher interest rate than the first mortgage.

These piggyback loans can also have variable rates, so your payment could increase or decrease over time.

5. Get a VA loan

Check with your mortgage lender to see if you’re eligible for a VA home loan.

These loans allow 100 percent financing and don’t require private mortgage insurance.

To qualify, you must be an eligible service member, a veteran, or an eligible spouse.

6. Ask about no down payment mortgages

You can also talk to your lender about “no money down” portfolio loans. Many banks sell their mortgages to either Fannie Mae or Freddie Mac.

If so, they must adhere to their underwriting standards. This typically involves charging PMI when a borrower puts down less than 20 percent.

But if a mortgage company or bank doesn’t sell its loans to Fannie Mae or Freddie Mac, they can write their own rules.

And sometimes, these banks will wave down payments if a borrower agrees to a higher mortgage rate. 

Zero-down loans aren’t available to everyone. Some banks reserve these loans for borrowers with the highest credit scores.

Although this is a way to buy a home with no money down, you’ll need to crunch the numbers to see if it makes good financial sense.

Remember, private mortgage insurance is often a temporary expense. A higher interest rate is permanent, unless you refinance the mortgage.

Final Word

Private mortgage insurance is an added expense.

But if you’re struggling to save money for a down payment, the ability to buy with less out-of-pocket can make your homeownership dreams a reality sooner. 

The good news:

PMI isn’t always permanent.

If you have a conventional loan, your lender will waive the insurance once you have enough equity.

And if you have a USDA or an FHA home loan, you can refinance your mortgage at some point to alleviate this cost.