How does private mortgage insurance work?

When purchasing a home with a conventional loan, you might be required to pay for private mortgage insurance (PMI). This is generally the case if your down payment doesn’t meet a certain threshold of the home’s purchase price. But you could also run into PMI requirements based on the type of mortgage program you use. Depending on the value of your home, PMI premiums can add hundreds of dollars to your monthly mortgage payments.

But what exactly is PMI? Here’s what you should know about how it works, how much it costs and whether you can avoid or eliminate this additional expense.

What is PMI?

Private mortgage insurance is a type of insurance that protects your mortgage lender if you stop making payments on a loan. PMI is typically required on conventional loans (or loans not backed by a government agency) when your down payment is less than 20% of the home price. Some lenders also offer first-time homebuyer programs that allow for low down payments without requiring PMI.

Keep in mind: Some government-backed loans also charge a form of mortgage insurance. For example, loans insured by the Federal Housing Administration (FHA) come with a mortgage insurance premium (MIP), and loans backed by the U.S. Department of Agriculture (USDA) require an annual guarantee. 

Note that these insurance programs have different terms and requirements than PMI. 

Different types of private mortgage insurance

There are four main types of PMI that you might come across during the process of getting a mortgage. These include:

• Borrower-paid PMI: This is the most common type of PMI, which involves the lender adding a monthly premium to your mortgage payment.
• Lender-paid PMI: With this approach, the lender pays for your mortgage insurance coverage with a lump sum when you close on the home. In return, you’ll pay a higher interest rate on your loan.
• Borrower-paid single-premium PMI: Similar to lender-paid PMI, the borrower-paid approach involves making a lump-sum payment made upfront at closing. But in this case, the payment is made by the buyer. Alternatively, you can opt to roll the single premium into your loan amount. Unlike with lender-paid PMI, however, you won’t have a higher interest rate as a result.
• Split-premium PMI: This option acts as a hybrid between borrower-paid and single-premium PMI. It allows homebuyers to pay a portion of the PMI premium upfront, resulting in lower monthly premiums moving forward.

How much does private mortgage insurance cost?

Though the exact cost varies by program, on average, PMI costs between 0.46% to 1.5% of your loan balance annually, according to an analysis by the Urban Institute. This expense is divided into monthly payments that are added to your mortgage bill. 

For example, say you purchase a $400,000 home and put 3% down (or $12,000), resulting in a loan amount of $388,000. If the PMI expense for that mortgage is 1.5% of the loan amount per year, your annual PMI cost would be $5,820. That premium would be divided over 12 months, meaning you’d pay $485 extra per month on your mortgage payment.

What affects PMI costs?

The amount you pay for PMI each month is impacted by several factors, including:

• Loan amount: Larger loans tend to require more coverage, which can result in higher insurance premiums.
• LTV ratio: Your loan-to-value (LTV) ratio is the percentage of the home’s value that’s financed by a lender. A low down payment translates to a high LTV ratio, which poses a greater risk for the lender if you stop making payments for some reason. As a result, a high LTV ratio will typically result in higher PMI rates.
• Credit score: Applicants who have higher credit scores are viewed by lenders as less likely to default on payments, which can result in lower PMI premiums.

Mortgage insurance vs. home insurance: What’s the difference?

Mortgage insurance can sometimes be confused with home insurance, but the two are very different. Even though you’re the one responsible for paying the premiums, mortgage insurance protects the lender if you default on the loan. It doesn’t provide any protection for you at all. 

Homeowners insurance, on the other hand, protects you against costs associated with repairing or replacing your home and personal belongings if they’re damaged or stolen due to covered perils, such as fire, wind or hail.

You’ll typically be required to have homeowners insurance if you have a mortgage loan. It’s also a good idea to have it even if you own the property outright. With PMI, however, you’ll only be required to have it if you don’t meet the typical requirement of making a down payment of at least 20% on a conventional loan.

Do you need private mortgage insurance?

There are a few instances in which mortgage lenders will require you to have PMI. Most commonly, you’ll need it if you purchase a home with a conventional loan and don’t make a down payment of at least 20%. You might also be required to have PMI if you refinance a conventional mortgage and have less than 20% equity in your home.

In general, you’ll have to maintain PMI coverage until your loan balance reaches the equivalent of 80% of your home’s value. At that point, you can ask to have your PMI canceled, eliminating this extra cost. 

Ways to avoid PMI

Whether you are buying a new home or have PMI on an existing loan, there are a few ways you can eliminate this costly expense.

Make a large down payment

The most straightforward way to avoid this expense is by putting 20% or more down on a conventional loan, in which case the lender won’t require PMI. If you can’t afford to make a large down payment on your own, you might consider asking loved ones to help you reach the 20% threshold.

Buy a less expensive home 

Even if you can manage the monthly payment on an expensive home, choosing a less costly option can make it easier to afford a 20% down payment, which in turn eliminates the PMI requirement.

Apply for down payment assistance 

Some state and local government agencies as well as non-profit organizations offer down payment and closing cost assistance to low-income homebuyers or first-time homebuyers. Taking advantage of one of these programs can help you reach your 20% down payment goal.

Look into no-PMI loan options

If you’re a first-time homebuyer, you might qualify for special loan programs that allow for a low down payment without PMI. 

“Programs that waive PMI are often subsidized by groups designed to promote homeownership,” says Dan Green, CEO of Homebuyer.com.

Apply for a piggyback loan

Some lenders allow you to skip PMI if you use a piggyback loan to cover the difference between your down payment and the 20% minimum requirement. This is a type of second mortgage loan that uses the home as collateral. 

Opt for a government-backed loan 

Loans backed by the Department of Veterans Affairs (VA) are another no-PMI option. These mortgages, which are available to service members, veterans and surviving spouses, don’t require a down payment or PMI. However, keep in mind that VA loans come with an upfront funding fee.

FHA and USDA loans also don’t require PMI. But they do require different types of insurance payments, so you’d still be paying a similar insurance-related expense. An FHA loan will come with an upfront mortgage insurance premium and an ongoing MIP. Depending on your loan, you might have to pay this MIP for 11 years or the entirety of the mortgage. A USDA loan, on the other hand, requires an upfront guarantee fee that acts as insurance for the loan. 

Choose lender-paid PMI 

Another option to avoid making monthly PMI payments is to go with lender-paid PMI — though remember that you’ll likely make up for this with a higher interest rate. As part of this arrangement, you must have at least 5% available for a down payment but not enough funds to put 20% down. In this case, the lender would give you a higher rate on your loan and would then use the additional interest from this to pay the PMI premiums. 

“Lender-paid mortgage insurance is usually a losing deal for a home buyer,” says Green. “Unlike traditional PMI, lender-paid is cooked into your interest rate and is permanent, which means it never goes away.”

Tip: If you’re unsure about your options, consult with a loan officer or mortgage broker to get an idea of what might work for you. 

How to get rid of PMI

There are several ways to get rid of PMI on a conventional loan. Here are some options to consider:

• Reach an 80% LTV ratio. When you reach the date that your LTV ratio is 80% of the original value of the home, you can submit a request seeking to have the PMI fee removed. You can also make extra payments on your mortgage to reach the 80% LTV mark faster.
• Get a new appraisal. If you think the value of your home has increased since you bought it, you might consider getting a new appraisal to check the current value. Be sure to contact your lender before you proceed, however, as there might be specific appraisal requirements for the results to be taken into consideration. There’s also no guarantee that an appraisal, which can cost a few hundred dollars, will give you the results you want.
• Refinance the loan. If you’re already planning to refinance your mortgage, the new lender will typically require an appraisal. If it results in an LTV of 80% or lower, PMI won’t be required on the new loan.
• Wait for automatic termination. If you don’t ask your lender to remove PMI once the LTV ratio hits 80%, it will automatically be removed when your loan balance reaches 78% of the original value of the home.

Keep in mind: These options only apply to borrower-paid PMI. Lender-paid PMI doesn’t work the same way because you’ve already paid for the PMI cost upfront in the form of a higher interest rate. Note that this can’t be undone — the higher rate for lender-paid PMI is permanent.