When buying a home, it’s important to understand the relationship between down payments and private mortgage insurance. If you make a down payment below 20%, you may be required to pay for extra insurance on the loan. Also referred to as PMI, private mortgage insurance is an additional cost that can increase the size of your monthly payments.
In this article, you will learn what PMI is, how much it might cost, and what you can do to avoid it. Let’s start with a basic definition:
What Is Private Mortgage Insurance?
If you make a down payment of less than 20% when using a mortgage loan, there’s a good chance you will have to pay for private mortgage insurance or PMI. This is a type of insurance that protects the lender in the event that you default on your loan. In this context, “default” means that you have stopped making your mortgage payments for some reason.
PMI is typically required for any home loan that accounts for more than 80% of the purchase price. When a lender makes a larger investment in a home (i.e., more than 80%), they also carry more risk. So they usually charge extra insurance to offset this added risk.
How PMI Helps the Lender and the Borrower
Without private mortgage insurance, many home buyers would be unable to purchase a home. Lenders would probably require everyone to make a down payment of at least 20%. This would put homeownership out of reach for a large percentage of Americans.
PMI enables borrowers to make a much smaller down payment — as low as 5% on a conventional mortgage loan. The lender is bearing more of the risk in a low-down-payment situation, so they require private mortgage insurance as an added protection. So PMI benefits both parties in this relationship. The lender gets extra protection against borrower default. And the borrower can obtain financing with less money down. It’s a way to bridge the risk gap.
How Much Does It Cost?
The cost of PMI will vary based on the size of the loan and the insurance company being used. Generally speaking, you can expect to pay somewhere between 0.5% and 1% of the loan amount on an annual basis. For example, this might come out to $50 – $80 per month on a $160,000 home ($600 – $960 per year). For a $200,000 home, PMI might cost $125 per month or more. The larger the loan, the higher the cost of private mortgage insurance.
This cost is generally rolled into the mortgage payment. There is an acronym used to describe the four components that can make up a monthly mortgage payment. That acronym is PITI. These letters stand for principal, interest, taxes and insurance. Principal refers to the principal amount being borrowed. Interest refers to the interest rate charged on the loan. Tax refers to the property taxes that might be rolled in the mortgage payment. And the second ‘I’ stands for insurance, which in this context refers to private mortgage insurance or PMI.
Do I Need PMI For a 15-Year Mortgage Loan?
It depends on the size of the loan in relation to the purchase price. If the 15-year mortgage accounts for more than 80% of the purchase price, then you will probably be required to pay for private mortgage insurance. Your lender has to disclose all of this, by the way. So there shouldn’t be any surprises along the way. If they require you to pay for PMI based on the size of your loan, they must disclose it to you upfront.
How Can I Avoid This Extra Cost?
It’s possible to avoid extra PMI costs, even when your down payment is less than 20%. Earlier, I stated that private mortgage insurance is usually required when a single loan accounts for more than 80% of the home’s purchase price. But if you can put together two different mortgages, and neither of them accounts for more than 80%, you could essentially avoid having to pay private mortgage insurance. This is often referred to as the “piggyback” strategy. You have a second mortgage loan that piggybacks on the first.
An example of this strategy is the 80-10-10 financing method. This is where you obtain one mortgage for 80% of the purchase price, and a second loan for 10% of the purchase price. You would pay the remaining 10% in the form of a down payment. You can do the math see that 100% of the purchase price is being covered. But neither of these two loans accounts for more than 80% of the purchase price. So you could likely avoid the extra cost of PMI when using this strategy.
The 80-15-5 mortgage is another example. The concept here is the same, but this time the borrower is making a down payment of 5%. The first and second mortgage loans account for 80% and 15% of the purchase price, respectively. So here again, there is no single loan covering more than 80% of the purchase price.
You may find it hard to find piggyback financing these days, when compared to the “easy credit” days of the housing boom. The mortgage meltdown that started in 2008 made a lot of lenders reluctant to offer this type of financing. But this will largely depend on where you live. So you shouldn’t rule it out entirely. Just do some research to see if piggyback mortgage loans are an option in your city and state.
How Do I Cancel PMI When the Time Comes?
Let’s assume that I’m buying a home, but I cannot afford a down payment of 20%. None of the lenders in my area are willing to offer piggyback financing (such as the 80-15-5 loan). As a result, my lender will require me to have private mortgage insurance on my loan. I am making a down payment of 10%, and they are financing the remaining 90%. So here we have a situation where a single loan accounts for more than 80% of the purchase price. This is a classic scenario where PMI will generally be required.
Over time, I will gain equity (ownership) in my home by making my mortgage payments. During the early years of the payback period, most of my payment will be applied to the interest on the loan. This is due to amortization. So the principal amount that I’ve borrowed won’t be reduced very much in the early years, if at all.
As I get further into the term of my loan, a higher percentage of my mortgage payment will be applied to the principal. So I will reduce the principal more quickly in the later years. As this happens, I will eventually reach the 20% equity mark. Once I’ve paid down my mortgage to the point that it equals 80% or less of the purchase price, I can request cancellation of my PMI coverage. If I’ve been current on my mortgage payments up to this point, the lender is required to honor my request. They must cancel the private mortgage insurance once I reach (or exceed) the 20% equity mark.
Once upon a time, it was solely the borrower’s responsibility to cancel PMI. This is still true at the 80% loan-to-value point. But once the loan-to-value reaches 78% or below, the lender must automatically cancel the PMI coverage. This is according to a new law that was passed in 1998, the Homeowners Protection Act or HPA. Again, this is assuming that the borrower is current on his mortgage payments. If the borrower is delinquent on the loan when it reaches 78% LTV, the lender is required to cancel PMI when the loan becomes current again.
Here’s the pertinent section of the HPA:
“A [mortgage] servicer must automatically terminate PMI for residential mortgage transactions on the earliest date that both the principal balance of the mortgage is firstscheduled to reach 78 percent of the original value of the secured property … and the borrower is current on mortgage payments.”
Those are two important numbers to keep in mind — 80% and 78%. When your mortgage balance reaches the 80% loan-to-value mark, you can ask your lender to cancel your private mortgage insurance. When you reach the 78% LTV mark, they must cancel PMI automatically. The second requirement is an important one, because a lot of homeowners forget to keep track of their equity / loan-to-value ratio.
If you fail to contact your lender when you reach the 20% equity point, you will probably continue paying for PMI coverage (even though you no longer need it). In the past, this might have gone on indefinitely. But the Homeowners Protection Act requires automatic cancellation when the mortgage reaches 80% loan-to-value ratio.
This article explains the relationship between down payments and private mortgage insurance. If you would like to learn more about the home buying process, you can use the search box located at the top of this page. We have hundreds of mortgage-related articles and tutorials on this website, so you’re bound to find some helpful information.
Brandon Cornett is a veteran real estate market analyst, reporter, and creator of the Home Buying Institute. He has been covering the U.S. real estate market for more than 15 years. About the author