Scraping together a 20% down payment for a mortgage can be a tall order, but that doesn't have to be a roadblock to getting a home loan, thanks to a financial instrument called private mortgage insurance.
Private mortgage insurance (PMI) is a form of insurance, paid for by the borrower, which protects the lender against financial loss in the event of foreclosure.
PMI is designated "private" to contrast it with mortgage insurance provided by the U.S. government through Federal Housing Administration (FHA) loans.
Lenders typically require borrowers to purchase mortgage insurance when the down payment on a mortgage is less than 20%. They also may require borrowers with low credit scores or significant negative events in their credit history (a foreclosure or bankruptcy, e.g.), to purchase PMI even with a down payment that equals or exceeds 20%.
PMI enables many borrowers to get mortgages despite poor credit, or with less than 20% down, but it comes at a cost. As we'll discuss below, you may be able to have PMI removed once you have a 22% stake in the property, but PMI still adds significantly to the total cost of a home.
Here's a rundown on how PMI works, including pros and cons, to help you decide if a loan with PMI is a good option for you.
See also: How to Get Pre-approved For a Mortgage
How PMI Works
For conventional mortgages (those not backed by government entities) lenders typically require a down payment of 20%. Put another way, conventional mortgage lenders require a maximum loan-to-value (LTV) ratio of 80%, where:
Appraised Home Value
On a $200,000 home, a 20% down payment of $40,000 would require a loan of $160,000, yielding an LTV ratio of 80%. The same home with a 15% down payment of $30,000 would require a $170,000 loan, which would mean an LTV of 85%.
Lenders seek 20% down payments (80% LTV) to offset the risk that the borrower will fail to repay the loan. (When lenders acquire properties through foreclosure, proceeds from down payments can help cover costs associated with re-selling them.)
If a lender agrees to give you a loan with an LTV greater than 80%, they will require you to purchase mortgage insurance that covers the difference between the amount you put down at closing and a 20% down payment.
In our hypothetical $200,000 home, if you make a 10% down payment (LTV = 90%), you'll need PMI coverage for $20,000, the amount of additional down payment you'd need for an LTV ratio of 80%.
When PMI is required, the lender arranges with a company that specializes in mortgage insurance (there are seven such companies in the U.S.) to provide the necessary policy. You as borrower have no say in the choice of PMI provider, so there's no opportunity to compare pricing.
What It Costs
The cost of private mortgage insurance varies by provider and by the size and type of loan. As you'd expect, premiums increase with the amount of coverage required, and PMI on adjustable-rate loans is pricier than that on fixed-rate loans.
The cost of PMI can range from 0.5% to 1% of the total loan amount per year—as much as one point on a mortgage loan. As a borrower, you can pay that cost in one of four ways:
- Monthly payments: The annual premium is spread across 12 payments, which are rolled into your mortgage statement. This is the most common PMI-payment scenario.
- Up-front payments: PMI is covered in a lump sum as part of your closing costs. This has the advantage of lowering monthly payments, but if you sell the home within a relatively short time, you could lose money on the deal. The lump-sum payment is non-refundable.
- Split premiums: In a blend of the first two options, a portion of the PMI policy is purchased up front, and the rest is covered in payments added to your monthly mortgage statements. This is not very common, but it's an option you can seek if you'd like to trade off higher closing costs for some reduction in monthly payments.
- Lender-paid PMI: In this scenario, the lender covers the PMI premium, and makes you pay for it in the form of higher interest rates. This is the approach lenders will likely impose on borrowers with poor credit. It is also probably the least desirable form of PMI for the borrower, as there is no way to remove the insurance cost over the life of the loan.
A PMI Alternative
If you have very good credit, you may qualify for an 80-20 loan, or "piggyback" mortgage, which lets you avoid PMI, put 0% down, and get into a home for just the closing costs. You do this by taking out a mortgage for 80% of the property value, and a second loan for the 20% down payment. Both the 80% loan and the 20% loan are secured against the home, so defaulting on either one could result in foreclosure.
Because 80-20 loans provide 100% financing for the home, lenders are very selective about issuing them. In addition to a great credit history, you may be required to show a strong record of regular employment, meet minimum requirements for savings and other assets; and demonstrate that your outstanding debts total less than 45% of your income. These strict lending requirements make 80-20 loans impractical for many borrowers, but they're an option worth considering if you meet the qualifications.
Getting Rid of PMI
While many borrowers welcome PMI as a means for buying a home, most are even happier to see PMI go away. It's possible to have PMI coverage removed once you've paid off enough of the loan to own 22% of the property's appraised value, or achieved an LTV ratio of 78%.
How long that could take depends on a couple of factors:
- The size of your down payment
- If you put down 10% on a 30-year loan at 4% interest, it would take about 7 years to reach 22% equity.
- With a 5% down payment, it would take nearly 9 years.
- Changes in appraised value
The closer your original down payment was to 22%, the sooner you'll get to 78% LTV. For example, with all other factors being equal, for our hypothetical $200,000 home:
Of course paying down your loan isn't the only thing that affects equity; your home's appraised value can also change with market conditions. If you buy in an area with rising home prices, appreciation on your property could get you to 22% equity sooner:
If we assume annual appreciation of 3%, our 10% down-payment example reaches 22% equity in less than three years, instead of about seven. On the flipside, a decline in property value could prolong the time needed to reach 22% equity.
If you'd like to get PMI removed from your loan eventually—and you definitely should, if you're able—ask your lender about the process up front, while discussing loan terms. You may have to pay for a new property appraisal (using an appraiser chosen by the lender)— a service that typically costs around $500 but which can cost double that or more if your home is exceptionally large or has features or amenities that aren't typical to your neighborhood.
That appraisal will determine the value of the home that's used when calculating your equity stake. If you've reached 22%, you can eliminate PMI. If you're not at 22%, you can try again anytime, but you may have to pay for another appraisal.
If eliminating PMI lowers your monthly costs, consider keeping your payments the same as they were when PMI premiums were included. That'll help you pay off your mortgage ahead of schedule, and save even more money over the life of the loan.