Why do I need to pay PMI insurance on my home loan?

Reader question: “I recently spoke to a friend of mine who works for a bank. I told him about my plans to buy a home, and the fact that I don’t have much money to put down up front. He said I would need to pay PMI mortgage insurance on the loan, before a lender would work with me. I’m still not clear on the reasons for this. Why do I have to pay for PMI on my loan?”

Let’s start with a basic definition, for the benefit of other readers. Private mortgage insurance (PMI) is a policy that protects lenders in the event that the borrower defaults (stops paying) on a home loan obligation. It is typically required in cases where the loan-to-value (LTV) ratio is higher than 80%.

Why Do I Have to Pay PMI on My Mortgage?

Getting back to your question: Why do you have to pay PMI on your home loan? If you put less than 20% down on a home loan, you will have to pay for private mortgage insurance. Borrowers who make down payments below 20% represent a higher risk for the lender, statistically speaking. So they are typically required to pay for PMI coverage.

According to the Consumer Financial Protection Bureau (CFPB):

“Lenders may require you to purchase PMI if your down payment is less than 20 percent of the sales price or the appraised value of the home. Premiums are added to your monthly mortgage payment.”

The cost of a policy ranges from 0.3% to 1.15% of the base loan amount, on average. This additional cost gets rolled into the monthly payments, increasing the amount you have to pay each month. That is why it’s best avoided, if at all possible.

You might have noticed a key point here. It is the borrower who pays for the policy, while the lender receives protection from the policy. This “reverse coverage” concept is unique to the mortgage industry. PMI is one of of the only types of insurance where the person paying for the policy receives no protection whatsoever. Welcome to the world of home finance!

Home loans are often bundled, securitized, and sold into the secondary mortgage market. Lenders and borrowers make up the primary market. The secondary market is made up of investors, Wall Street, and other financial exchanges. Generally speaking, investors steer clear of uninsured loans for more than 80% of the home value, due to the higher risk they carry. So if a lender gives you a loan for more than 80% of the value, but they don’t require mortgage insurance, they’ll have a harder time selling it into the secondary market.

How to Avoid This Extra Cost

So that explains why you have to pay for PMI coverage when your down payment is less than 20%. Now, let’s talk about what you can do to avoid this extra cost entirely.

As mentioned above, borrowers usually have to pay PMI when any single loan accounts for more than 80% of the appraised home value. The key word here is “single.” But what if you used two separate mortgage loans to pay for the house? This is a common strategy used by home buyers who have less than 20% saved up for a down payment.

For example, you could use an 80-10-10 mortgage to buy a house, and you wouldn’t have to pay for a PMI policy.

Here’s what those numbers represent:

• 80 = The first mortgage would cover 80% of the purchase price.
• 10 = The second home loan (also called a “purchase money second”) would cover 10% of the price.
• 10 = You, as the borrower, would pay the remaining 10% out of pocket as a down payment.

In this “piggyback” financing scenario, no single loan accounts for more than 80% of the price. Therefore, you wouldn’t have to pay for PMI protection, even though you are putting less than 20% down on the home purchase.

Next question: This article answers the question, Why do I need to pay for private mortgage insurance? The next logical question is, how much does it cost? Here is an updated look at the average cost of these policies.