What Is PMI (Private Mortgage Insurance)?
Short answer
PMI, or Private Mortgage Insurance, is insurance a borrower pays to protect the lender when the down payment on a home is less than 20%. It adds to your monthly mortgage payment and lasts until you build enough equity to cancel it, helping you qualify for a mortgage with a smaller initial payment.
What Is PMI in Plain Words?
Private Mortgage Insurance (PMI) is a type of insurance that protects the lender if a borrower stops paying the mortgage loan. It is usually required when a borrower puts down less than 20% of the home’s purchase price. Because the lender is taking on more risk with a smaller down payment, PMI reduces that risk by covering some losses if the borrower defaults.
PMI is paid by the borrower but benefits the lender, not the homeowner. It is separate from homeowner’s insurance, which covers damage to your property. PMI only relates to the loan balance and protects the lender’s financial position, allowing borrowers who cannot afford a large down payment to buy a home.
For example, if you buy a home for $250,000 but can only afford a $15,000 down payment (6%), the lender will require PMI to cover the added risk. PMI enables the lender to approve your loan despite the smaller down payment.
How Does PMI Work? A Step-by-Step Example
Suppose you buy a $350,000 house with a 10% down payment of $35,000. The loan amount is $315,000, which is 90% of the home's price. Because the down payment is under 20%, the lender requires PMI. Your lender or mortgage insurer calculates the PMI premium based on your credit score, loan amount, and loan type.
If PMI costs 0.5% annually of your loan amount, it would be about $1,575 per year or roughly $131 per month added to your mortgage payment.
Here’s a simplified payment breakdown:
| Item | Amount |
|---|---|
| Home price | $350,000 |
| Down payment (10%) | $35,000 |
| Loan amount | $315,000 |
| Annual PMI (0.5%) | $1,575 |
| Monthly PMI | $131 |
Your monthly mortgage payment includes principal, interest, property taxes, homeowner’s insurance, and PMI. This $131 is an extra cost for as long as PMI is required.
PMI usually stays in place until your outstanding loan balance reaches 80% of the home’s original value, which in this case is $280,000. You can request PMI cancellation at that point. For example, after a few years, if you have paid down your mortgage to $280,000 or less, you can formally ask your lender to drop PMI, reducing your monthly payment.
Why Does PMI Matter for You?
PMI affects your monthly housing costs and your ability to qualify for a mortgage. Since PMI increases your monthly payment, it influences how much home you can afford and how much of your income will go toward housing expenses.
For example, if your gross monthly income is $4,000 and your lender recommends that no more than 28% of your income goes to housing, that means you should spend no more than $1,120 monthly on mortgage-related costs. If PMI adds $150, that reduces the amount available for principal, interest, taxes, and insurance to $970, which might affect the home price you can afford.
Understanding PMI helps you plan your budget and decide whether to save for a larger down payment to avoid or reduce PMI or accept PMI costs temporarily.
PMI also impacts your ability to refinance. If your home value increases, you might be able to refinance to a loan without PMI, saving money in the long run.
How Is PMI Different from Other Insurance Related to Mortgages?
People often confuse PMI with other insurance types involving mortgages:
- Mortgage Protection Insurance: This insurance pays your mortgage if you die or become disabled. It protects your family, not the lender. It is optional, unlike PMI which is often required.
- Homeowner’s Insurance: Protects your home from damage or loss due to fire, theft, or natural disasters. This insurance is mandatory for most mortgages but does not cover loan default.
- FHA Mortgage Insurance Premium (MIP): Required for FHA loans, this insurance protects the government-backed loan. Unlike PMI, FHA MIP includes upfront and annual premiums and usually lasts for the life of the loan.
- Hazard Insurance: A component of homeowner’s insurance covering specific risks like flood or fire damage, unrelated to mortgage default risk.
Knowing these differences helps you avoid confusion and understand what you are paying for. For example, you might have both PMI and homeowner’s insurance premiums in your monthly mortgage payment but for very different reasons.
How Can You Avoid or Remove PMI?
Avoiding PMI means saving at least 20% for your down payment. If that’s not possible, here are ways to remove PMI later:
- Pay Down Your Mortgage: Make extra payments to reduce your loan balance to 80% of the home’s original value. For example, if you owe $260,000 on a home originally worth $325,000, you can ask your lender to cancel PMI.
- Request PMI Cancellation: Once you reach the 80% loan-to-value ratio, write a formal cancellation request to your lender. They may require a home appraisal to confirm the value.
- Refinance Your Mortgage: If your home’s market value has increased and you have enough equity, refinancing to a new loan without PMI may save money.
- Use Lender-Paid Mortgage Insurance: Some lenders offer loans with no PMI but higher interest rates. This option avoids monthly PMI payments but may cost more over time.
Keep track of your mortgage balance and home value, and review your loan documents to understand the PMI cancellation process. Lenders must cancel PMI automatically once the loan balance hits 78% of the original value, but you can often request cancellation earlier.
What Are the Costs and Payment Methods for PMI?
PMI costs vary widely depending on your credit score, loan size, down payment, and loan type. Typical annual PMI premiums range from 0.3% to 1.5% of the original loan amount.
There are three common ways to pay PMI:
- Monthly Premiums: Paid as part of your monthly mortgage payment, the most common method.
- Upfront Premium: A one-time payment at closing. Some loans combine upfront and monthly premiums.
- Lender-Paid PMI: The lender pays PMI but increases your mortgage interest rate, indirectly increasing your monthly payment.
For example, if your loan is $300,000 and your PMI rate is 0.7%, your annual PMI cost would be $2,100, or about $175 per month added to your mortgage payment.
Understanding how PMI is charged helps you budget better and compare loan offers. It’s wise to ask lenders for exact PMI costs and payment options before committing.
What Should You Do Next If You’re Planning to Buy a Home?
If you’re preparing to buy a home, follow these steps regarding PMI:
- Check Your Credit Score: Higher scores typically get lower PMI rates. Use a free credit report service to know your score before applying.
- Save for a Down Payment: Aim for at least 20% to avoid PMI or minimize it.
- Ask Lenders About PMI: When comparing loan quotes, request detailed PMI cost estimates.
- Understand Your Loan Options: Conventional loans usually require PMI with less than 20% down, but some programs offer alternatives.
- Plan to Remove PMI: Budget extra payments or track home value increases to cancel PMI sooner.
- Read Your Loan Documents Carefully: Look for PMI terms and cancellation rights.
Taking these steps helps manage costs, improve your mortgage terms, and avoid surprises. For more foundational knowledge, see articles explaining why mortgage insurance is required and how to explain mortgage insurance to kids.
Frequently asked questions
Can PMI premiums be canceled automatically?
Yes. Under federal rules, lenders must automatically cancel PMI once your loan balance reaches 78% of the home's original value, as long as payments are current. You can also request cancellation earlier at 80% loan-to-value.
Does PMI protect me if I miss mortgage payments?
No. PMI protects the lender, not the borrower. If you miss payments, PMI doesn’t cover your costs or prevent foreclosure.
Can I get a mortgage without PMI if I have a low down payment?
It’s difficult. Some specialized loans or piggyback loans avoid PMI, but they often have higher interest rates or fees. Most conventional loans require PMI below 20%.
How does my credit score affect PMI cost?
A higher credit score generally means lower PMI premiums because you are considered less risky. Improve your credit score before applying for better PMI rates.
Is PMI refundable if I refinance or sell my home?
PMI is not refundable like some insurance. If you refinance or sell, you stop paying PMI, but past premiums are not returned.