What is Private Mortgage Insurance (PMI) and how does it do its job?

If you’re buying a home and not able to put down a 20% down payment, you may have to pay Private Mortgage Insurance, or PMI for short. While it can increase your monthly mortgage bill, it allows for you to become a homeowner sooner if you have limited upfront funds.

Private Mortgage Insurance (PMI) is a financial product that comes into play for homebuyers who make a down payment of less than 20% of a property's purchase price. While PMI offers a pathway to homeownership, it is an added monthly cost that you should be aware of. Learn more about the reason for PMI, how it works, how to get rid of it, and more.

PMI: What is it and when did it originate?

PMI insurance serves as protection for lenders in case borrowers default on their mortgage payments. When homebuyers provide a down payment of less than 20%, lenders perceive a higher risk. PMI mitigates this risk by offering financial coverage to the lender, making them more willing to approve mortgages with lower down payments.

A history of PMI

The concept of private mortgage insurance gained traction during the 1950s and 1960s. The Federal Housing Administration (FHA) and the Veterans Administration (VA) had been providing government-backed mortgage insurance, but private insurers started offering alternatives for conventional loans.

The 1970s saw further development in the private mortgage insurance industry. As more homebuyers sought financing, PMI mortgage insurance became a more common requirement, particularly for those who couldn't make a substantial down payment.

Later on, The Homeowners Protection Act of 1998 established rules regarding the cancellation and termination of private mortgage insurance. This legislation aimed to protect homeowners by ensuring that they had a clear understanding of when they could request the removal of PMI.

Why do lenders require PMI?

Lenders charge Private Mortgage Insurance (PMI) to mitigate the increased risk they undertake when providing mortgages with down payments of less than 20%. Here are the primary reasons why lenders charge PMI:

• Risk mitigation: When a borrower makes a down payment of less than 20%, the lender assumes a higher risk. A larger down payment acts as a financial cushion for the lender, reducing the likelihood of financial loss in case of borrower default. 
• Loan-to-Value ratio (LTV): Lenders assess risk based on the Loan-to-Value ratio, which is the ratio of the mortgage amount to the home's appraised value. The higher the LTV, the riskier the loan is perceived to be. Charging PMI allows lenders to mitigate risk associated with higher LTV ratios, especially when borrowers have minimal equity in the property.
• Market conditions and regulations: In some cases, lenders may be required by law or regulation to charge PMI. Government-sponsored entities such as Fannie Mae and Freddie Mac, as well as the Federal Housing Administration (FHA), have guidelines that lenders must follow when originating mortgages with lower down payments.

How much does PMI cost?

PMI mortgage costs vary, typically ranging from 0.3% to 1.5% of the original loan amount annually. The actual cost depends on factors like the size of the down payment, credit score, and the type of mortgage you get. Some borrowers may encounter a higher PMI premium if they are assessed to be a higher risk to the lender.

Pros of PMI

• Access to homeownership: PMI allows homebuyers to secure a mortgage with a lower down payment, making homeownership more accessible.
• Faster entry into the housing market: With PMI, buyers can enter the housing market sooner, benefiting from potential property appreciation.
• Flexibility: PMI enables borrowers to conserve savings, offering more financial flexibility for other purposes.

Cons of PMI

• Additional cost: PMI adds an extra cost to monthly mortgage payments, increasing the overall expense of homeownership.
• Cancellation challenges: While borrowers can request PMI cancellation once they reach 20% equity, achieving this can be a gradual process, especially in markets with slower property value appreciation.

Can you get out of PMI payments?

It's important to note that PMI insurance is not a permanent cost for borrowers. Once you achieve at least 20% equity in the property through a combination of mortgage payments and potential property value appreciation, you can request the cancellation of PMI. 

For example, say your home was worth $400,000 when you bought it, but the home value increases to $500,000 after a few years. At the same time, you’ve been making payments and your principal balance has been going down. If you crunch the numbers and realize that you have achieved 20% equity, you can call your mortgage company to request a review to cancel your PMI. They will likely require an appraisal to confirm your home value, and if you meet the 20% threshold, you will no longer have to pay.

The other way to be released from having to make PMI payments is to wait it out. Under the Homeowners Protection Act (HPA), lenders are generally required to automatically terminate PMI when the loan-to-value ratio reaches 78%, provided you are current on your payments.

Opting for no PMI mortgage

If the idea of paying PMI doesn’t work for you, you could look into an alternative loan program from lenders that offer no PMI mortgages. Just note that these often come with other trade-offs, such as higher interest rates or fees.

Making an informed decision

Understanding the role of PMI in the homebuying process can empower you to make informed decisions about your mortgage. While PMI facilitates homeownership for those with limited upfront funds, it's crucial to weigh the costs and benefits. Exploring options for no PMI mortgages can provide alternatives if you’re seeking to minimize additional expenses. As always, consulting with mortgage professionals and financial advisors can offer insights based on your individual circumstances.