How Private Mortgage Insurance Works and When It’s Required

When purchasing a home, many buyers face the challenge of coming up with a down payment large enough to meet a lender's requirements. For most conventional loans, lenders typically expect a down payment of at least 20%. However, not all homebuyers can afford to put down that much upfront. This is where Private Mortgage Insurance (PMI) comes in.

PMI is designed to protect the lender in case the borrower defaults on the loan, making it a vital part of the home-buying process for those who are unable to make a 20% down payment. While PMI can be an extra cost for homebuyers, it opens the door for many to purchase a home without needing to save a large sum. In this article, we’ll take a deep dive into PMI, explaining how it works, the types available, the associated costs, and when it can be removed.

What Is Private Mortgage Insurance (PMI) and How Does It Work?

Private Mortgage Insurance is an insurance covering the lender from the risk of defaulting by the borrower. It is usually required when a borrower cannot afford to make a 20% down payment on a conventional loan. If there were no PMI, lenders would be at greater risk while lending money to buyers who may not have significant equity in their homes. A prime benefit offered by PMI is providing a cushion to lenders as they recover their losses should the borrower be unable to make payments toward their mortgage.

While this may be extra money added to the overall amount borrowers pay, PMI enables one to receive a loan that can be borrowed with just a small down payment. The type of mortgage decides whether PMI will be paid monthly, added upfront, or a mixture of the two. However, when the borrower fails to make payments, it pays some of the amount that still remains outstanding on the part of the loan. Thus, PMI decreases the risk of finance to lenders.

It is worth noting that PMI only benefits the lender, but it does not in any way protect the borrower. Thus, borrowers should perceive PMI as a necessary step to purchasing a home rather than a benefit.

Types of Private Mortgage Insurance

Borrower-Paid Mortgage Insurance (BPMI)

The most common form of PMI, BPMI, requires the borrower to pay monthly premiums as part of their mortgage payment. This premium is typically rolled into the borrower's monthly mortgage payment. BPMI is often the most affordable option in the short term but can lead to higher monthly costs for the borrower.

Lender-Paid Mortgage Insurance (LPMI)

In this arrangement, the lender pays for the PMI on behalf of the borrower. However, this usually results in a higher interest rate on the loan. While LPMI removes the monthly premium burden from the borrower, the higher interest rate can end up costing the borrower more over time. This option is typically preferred by borrowers who don’t want to deal with the extra monthly payments.

Single-Premium PMI

In this case, the borrower pays the entire PMI premium upfront in a lump sum. This type of PMI can be appealing to borrowers who can afford to make a large payment at the time of closing, as it eliminates monthly PMI payments. However, it may not always be the most cost-effective option in the long run.

Split-Premium PMI

This option is a hybrid between BPMI and single-premium PMI. Borrowers pay part of the PMI premium upfront, and the rest are part of their monthly mortgage payments. This option can be beneficial for borrowers who want to reduce their monthly payments while avoiding a large upfront cost.

The Cost of PMI: What to Expect

PMI costs depend on several factors, such as the loan amount, the down payment size, and the lender's specific criteria. Typically, PMI costs range from 0.3% to 1.5% of the original loan amount annually. For example, if a borrower has a $200,000 mortgage and the PMI rate is 1%, the annual PMI cost would be $2,000, or approximately $167 per month.

The exact cost will depend on the size of the down payment. The lower the down payment, the higher the PMI rate will typically be. For instance, if a borrower puts down only 5%, they can expect to pay a higher PMI rate than someone who puts down 10% or 15%. The cost can also fluctuate based on the borrower’s credit score, the type of loan, and the lender’s policies.

While PMI adds an additional cost to a borrower’s monthly payment, it’s often necessary for those who don’t have a large enough down payment to avoid it. Borrowers should factor the cost of PMI into their overall mortgage budget to ensure that they can comfortably afford their monthly payments.

When Can PMI Be Removed?

PMI is typically required until the borrower has built enough equity in their home. The timing of PMI removal depends on several factors:

Automatic Termination: Federal law mandates that PMI is automatically removed when the loan balance reaches 78% of the home’s original appraised value, provided the borrower is current on payments.

Borrower-Initiated Termination: Borrowers can request PMI removal once they have 20% equity in the home by contacting the lender, often providing evidence of the home’s current value through an appraisal.

Refinancing: Homeowners can refinance if the home’s value has increased, allowing them to take out a new loan with a lower loan-to-value ratio, thereby removing PMI.

In some cases, PMI may remain for the life of the loan, especially if the loan is high-risk or the property value decreases. It's important for borrowers to stay in contact with their lenders to understand their options.

Conclusion

Private Mortgage Insurance (PMI) is a crucial tool that allows many homebuyers to purchase a home without a large down payment. While it may seem like an added expense, PMI can provide the opportunity to enter the housing market sooner rather than later. Understanding how PMI works, the different types available, the costs involved, and when it can be removed is essential for homebuyers. By thoughtfully evaluating these factors, borrowers can make well-informed choices that align with their financial circumstances and homeownership objectives.