What is private mortgage insurance and how does it work?

Private mortgage insurance protects lenders, but homeowners must pay for it.  (iStock)

In 2019, the median home down payment was 6 percent for first time home buyers and 12 percent for all buyers, according to the National Association of Realtors. Low down payments make it easier for buyers to afford homes, especially in high-cost areas. But if a buyer with a conventional mortgage makes a downpayment of less than 20 percent of the home's value, private mortgage insurance (PMI) is required.

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Private mortgage insurance can add to your monthly mortgage costs and it provides protection for lenders, not for you. Still if you can't save a larger down payment, paying PMI may be necessary to enable the purchase of a home.

What does PMI insurance pay for – and how does it work?

Private mortgage insurance is generally required as a condition of loan approval by conventional loan lenders when you don't put down at least 20 percent on a home or if you take a cash-out refinance loan for more than 80 percent of your home's value.

Conventional loans are simply loans not backed by the government. For borrowers who take out most government-guaranteed loans -- including those insured by the Federal Housing Administration or US Department of Agriculture -- mortgage insurance is also required but works slightly differently.

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The purpose of private mortgage insurance is to make sure lenders making conventional loans are fully compensated if they must foreclose on the loan. When you make a small down payment, there's a risk they won't receive enough to repay the loan and their costs if they foreclosed and sold the home. To protect themselves, lenders obtain insurance through private companies and pass the cost onto you.

Although you pay for this private mortgage insurance, it doesn't benefit you directly. If you can't make your mortgage payments, you'll still be subject to foreclosure and could lose money when the bank takes your home.

How do you calculate PMI insurance?

The cost of private mortgage insurance varies by lender but must be disclosed to you when you shop for a home loan. It's priced as a percentage of the total cost of the home and can range between .55 percent and 2.25 percent, according to research from Genworth Mortgage Insurance, Ginnie Mae, and the Urban Institute.

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Your credit score, the amount you're borrowing, the amount of your down payment and whether your loan rate is fixed or variable all play a role in determining the amount you'll pay for PMI. To calculate your cost, simply multiply the amount you're borrowing by the premiums. For example:

  • If your PMI premiums cost .55 percent and you borrow $250,000, you'd pay $1,375 per year
  • If your PMI premiums cost 2.25 percent and you borrow $250,000, you'd pay $5,625 per year
  • If your PMI premium costs .55 percent and you borrow $480,000, you'd pay $2,640 per year
  • If your PMI premium costs 2.25 percent and you borrow $480,000, you'd pay $10,800 per year

Unfortunately, you can't shop around to find the most affordable PMI as your lender procures coverage and the amount you owe for it is added onto your monthly mortgage payment or paid to your lender in a lump sum each year. But you can get quotes from several mortgage lenders to find out which loan is the most affordable overall, including when private mortgage insurance is factored in.

The good news is, PMI premiums are tax-deductible – but you need to itemize on your taxes to claim the tax savings.

How can I avoid PMI?

The big benefit of PMI is that it enables you to get approved for a home with a low down payment. But you can avoid the expense associated with this insurance by making a down payment of at least 20 percent of the value of the home you're buying.

In some cases, it's also possible to find a loan that won't come with this added cost even if you put less than 20 percent down. VA loans don't require eligible borrowers to pay mortgage insurance premiums, for example. And some conventional lenders offer special loan options that waive PMI, although credit score and income requirements vary for them.

You can also get PMI removed from your loan by making a written request to your lender once your mortgage balance drops to 80 percent of your home's value. This can happen as your home appreciates or as you make payments – and paying extra accelerates the process. Your lender may impose requirements such as an appraisal or on-time payment history, though, in order for the PMI to be removed.

And once your loan is below 78 percent of the home's original value, lenders are required to terminate PMI on conventional loans as long as you aren't behind on payments at the time.