What is PMI, and who has to pay it?

Private mortgage insurance, sometimes called lenders mortgage insurance, is usually required whenever a home is purchased with less than 20% down. Lenders are most confident in a person's ability to pay back a home loan when that person has skin in the game to the tune of 20% of the home's sale price or appraised value. To enter into business with someone making less of a down payment, lenders want an insurance policy to cover their risk.

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Unlike your homeowners insurance or medical insurance, PMI doesn't protect you—it protects the lender. That's the tradeoff for being able to buy a home with as little as 3.5% down (the minimum required for a government-backed, FHA loan). The insurance covers the lender in the event that you default on the mortgage and go into foreclosure.

"I used to think mortgage insurance was in case you lost your job and couldn't make the payments," said Rate Simple borrower Kathy B. "I thought it covered your payments until you could get back on your feet, but that kind of insurance is actually job loss insurance and it's completely different from PMI."

One big benefit of a VA home loan is that qualified veterans can buy a home with as little as $0 down and no PMI because military service speaks for their reliability and dependability in lieu of a 20% down payment.

How Much Does PMI Cost?

The premium you pay for PMI will be based on your credit score and the loan-to-value ratio of the property you are buying. As we mentioned, lenders are most comfortable lending someone 80% of a property's value while that person invests his or her own cash for the rest. Before the homeowner even moves in, the home has 20% cash equity. This is an 80:20 ratio of loan to value (LTV), no mortgage insurance required.

The more unbalanced the ratio, the higher the insurance premium. For example, someone paying 5% down (95:05 LTV) will pay a higher premium than someone paying 15% down (85:15).

Credit score comes into play as well.

Two people who each put the same money down on homes of the same price will pay different mortgage insurance premiums if their credit scores differ. For example, someone with a credit score under 700 will pay more than someone with a score of 760, everything else being equal.

Expect your PMI payment to be 0.3% to 1.15% of your home loan. A ballpark estimate is that PMI costs $55 a month for every $100,000 borrowed but can be as high as $125 on a $200,000 loan. For example, let's say you paid 5% down on a $200,000 home and take on mortgage insurance at the rate of 0.78%. Your PMI payment would be $125, for an annual total of $1,500.

PMI is tax deductible.

Don't Some Lenders Offer to Pay the PMI?

Lenders that advertise home loans for low down payments and "no mortgage insurance" are not basking in a glow of generosity. Chances are that they plan to make you pay for insurance in a roundabout way. This is called "lender-paid PMI."

Instead of an insurance premium that you pay monthly, the cost is reflected in a higher interest rate, or rolled into the loan amount, or both. With all this extra money you are paying, the lender takes out mortgage insurance behind the scenes. They may call it lender-paid PMI, but it's still the homeowner who pays every penny in the long run. Even worse, this mortgage insurance by another name may last the life of the loan, which is not the way PMI generally works (keep reading).

How to Escape Your PMI

You can ask a lender to cancel your PMI as soon as you attain 20% equity in your home, though you will have to pay for the reappraisal. Now that your loan-to-value ratio is 80:20, you deserve the same high esteem from the lender as someone who paid 20% down. Ask your lender to cancel the PMI.

Once you attain 22% equity in your home, the lender must automatically cancel your PMI.

One exception is an FHA loan, where the mortgage insurance premium (MIP) lasts the life of the loan. Since FHA loans are government-backed, you aren't paying premiums to a private insurance company but rather to the government, hence the different name for the insurance. However, you can refinance out of the FHA loan as soon as you attain 20% equity, and there will be no mortgage insurance on the new loan.

While most borrowers balk at the idea of paying PMI, that's the tradeoff for the opportunity to buy a home with less than 20% down.

How to Avoid PMI in the First Place

Paying 20% down is the surefire way, but you already know that. Here are three ways you can avoid otherwise mandatory PMI, but note the drawbacks.

Pay higher interest. This is where lenders hide the cost of the mortgage insurance they take out on your loan when the loan has "lender-paid PMI." Beware: Unlike regular PMI, this can't be canceled once you attain 20% equity. You'll need to refinance to escape it.
Pay for a reappraisal. If you've made improvements to the property or the home values in your neighborhood have risen, you may be closer to attaining 20% equity than you realize. Only a reappraisal will tell for sure.
Borrow your 20% down payment with another loan. You can "piggyback" a down payment loan onto your home loan, but do the math. Piggyback loans come with a higher interest rate, so it may be more cost-effective to pay the PMI.

One final way worth mentioning to avoid PMI applies to buyers with excellent credit and valuable assets and who also meet other requirements but for whatever reason don't want to put 20% down. Lenders might wave the PMI requirement for these exceptional borrowers.

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How You Can Avoid Paying PMI

Putting 20% down is the surefire way to avoid PMI, but here are three other ways.