PMI is a type of mortgage insurance that buyers with less than a 20% down payment are typically required to pay for a conventional loan. Many lenders offer programs with low down payment requirements, allowing you to put as little as 3% down. The cost of this flexibility is private mortgage insurance (PMI), which protects the lender's investment in the event that you default on your mortgage payments. Thus, PMI insures the lender and not you.

What is PMI and all about PMI Mortgage Insurance

PMI aids lenders in recovering more money in the event of a default. Lenders require coverage for down payments of less than 20% of the purchase price because you have a smaller stake in the property. Therefore, mortgage lenders stand to lose a greater amount if you default during the first few years of ownership. FHA loans, which are insured by the Federal Housing Administration, also require mortgage insurance, but the guidelines for FHA loans differ from those for conventional loans (which we will discuss later).

The Cost of PMI

Freddie Mac, a government-sponsored enterprise that purchases and sells mortgages on the secondary mortgage market, reports that the average monthly payment for every $100,000 borrowed is between $30 and $70. Keep in mind that this amount can vary based on your credit score and loan-to-value ratio — the ratio of the amount you borrowed on your mortgage to the value of your home.

Historically, you could deduct the cost of PMI from your federal taxes. Congress decided to renew this provision for 2021, allowing you to deduct PMI payments from your annual taxes. (In fact, the deduction was reinstated only for 2017). Then, as a result of the COVID-19 pandemic, it was extended through 2020 and 2021 and made retroactive to 2018 and 2019.)

Paying for PMI

You have two payment options for PMI: an upfront, one-time premium or monthly premiums. In many instances, lenders include PMI as a monthly premium in the monthly mortgage payment. When you receive your loan estimate as well as closing disclosure documents, your PMI amount will be itemized on the first page of each document's Projected Payments section.

Another alternative is to include PMI in your closing costs. This premium is listed on the loan estimate and closing disclosure forms, page 2, section B. The disadvantage of this option is that you will likely not receive a refund if you move or refinance your mortgage. In some instances, you may be required to pay upfront and monthly premiums.

Canceling the PMI Coverage

The good news is that PMI will not be required for the duration of a conventional loan.

In one of three ways, the federal Homeowners Protection Act eliminates PMI.

• borrower-initiated cancellation;

• automatic cancellation;

• final cancellation

You can request PMI cancellation once your loan-to-value ratio falls below 80% of your home's original appraised value (or earlier if your home's value increases before then). This date is listed on the PMI disclosure form, which you probably received with your closing documents.

To cancel PMI, you must:

• submit a written cancellation request.

• Maintain current monthly mortgage payments.

• Have a satisfactory payment record (no more than one payment that was 30 days late in a 12-month period or no more than one payment that was 60 days late in a period of 24-month, according to Fannie Mae and Freddie Mac).

• Has satisfied all requirements of the mortgage holder. The property's value should not fall below the original purchase price and have no junior liens (such as a second mortgage)

Automatic Termination of PMI

Automatic PMI termination occurs when your remaining mortgage balance reaches 78% of the loan-to-value ratio (LTV) as predicted. By this date, lenders are required by law to automatically cancel PMI. The same conditions for borrower-initiated PMI cancellation apply here as well (history of on-time payments and absence of liens). If you have had late payments then your lender will not cancel PMI until your payments become current.

Final PMI Termination

The last PMI termination is known as the final PMI termination. Even if you haven't reached 78% LTV, the lender must automatically cancel PMI the month after your loan term's midpoint on the repayment schedule.

If you have a 30-year fixed loan, for instance, the midpoint would occur after 15 years. Again after 15 years, you must be current on your payments to get qualify. Typically, this type of PMI cancellation applies to loans with unique characteristics, such as balloon payments, an interest-only period, or principal forbearance.

Value of Home and PMI

Your eligibility to cancel PMI also depends on whether the value of your home has increased or decreased over time. If it rises, you can cancel PMI sooner than anticipated; if it falls, you will have to wait longer to cancel PMI.

Before cancelling PMI, a lender will determine your home's current market value using a Broker Price Opinion, a certification of value, or another form of property appraisal.

If your home's value has decreased due to a market downturn, your lender will likely deny your PMI cancellation request unless you obtain a new appraisal and reduce your loan balance to 80% of the new appraised value.

On the other hand, your home's value may increase faster than anticipated due to market conditions or renovations, meaning you may reach the 80% LTV threshold earlier than anticipated. In this case, you can request cancellation of PMI in advance, and your lender will order an appraisal to confirm the current value of the home. (Note: You are responsible for the property appraisal fee, which can range between $300 and $400. This amount may vary based on the size and location of the home.)

Conventional Loans Without Private Mortgage Insurance

Some lenders offer their own conventional loan products without requiring PMI, but they typically charge higher interest rates to protect themselves in the event of a default. Depending on how long you stay in your home and how long you keep the same mortgage, this may be more or less expensive than paying PMI in the long run.

This is where mortgage comparison shopping can be helpful. Compare the interest rates offered on loans with and without PMI. Calculate the difference between the two to determine the additional cost of a loan without PMI. Is this amount less than the PMI payments you'll make until your loan-to-value ratio reaches 80%? Remember that the value of your home could rise or fall, affecting how long you may be required to pay PMI. A mortgage calculator can clearly show how different interest rates affect your monthly payment.

Down Payment Requirements

Putting 20% of the purchase price of a home down eliminates PMI, which is the best course of action if you can afford it. Consider buying a less expensive home in addition to saving regularly for a down payment.

A more conservative budget for house hunting will reduce the amount required for a 20% down payment.

Piggyback Mortgages and PMI

Some lenders suggest using a "piggyback" second mortgage to avoid PMI. This can help reduce initial mortgage costs instead of paying PMI. It works as follows: You obtain a mortgage for the majority of the home's purchase price (minus your down payment amount). The remainder of the home's purchase price, minus the first mortgage and down payment amounts, is then covered by a second, much smaller mortgage. Thus, you avoid PMI and have combined payments that are less than the cost of the initial mortgage with PMI.

Nevertheless, a second mortgage typically carries a higher interest rate than the first. When the LTV reaches 80%, the only way to eliminate a second mortgage is to pay off the loan in full or refinance it (along with the first mortgage) into a new standalone mortgage (to avoid PMI). However, these loans can be expensive, especially if interest rates rise between the time you obtain the initial loan and the time you refinance both loans into a single mortgage. Refinancing both loans into a single loan will require you to pay closing costs a second time.

FHA Mortgage Insurance Premium

If you are not eligible for a conventional loan, you may want to consider an FHA loan. FHA loans, like some conventional loan products, offer a low down payment option (as little as 3.5% down) and looser credit requirements.

All FHA loans are required to have mortgage insurance, which is paid in two parts: an upfront mortgage insurance premium and an annual mortgage insurance premium. On the first page of your loan estimate and closing disclosure, both fees are detailed.

The Upfront Insurance Premium

1.75 percent of the loan amount constitutes the upfront mortgage insurance premium (UFMIP). You can either pay it upfront at closing or roll it into your mortgage. If you decide to include UFMIP in your mortgage, your monthly payments and overall loan costs will increase.

The yearly Premium

In addition to the UFMIP, you will pay an annual MIP that is split into equal monthly payments and rolled into your mortgage payments. Depending on the size and term of your loan, you will pay between 0.45% and 1.05% of the loan amount.

Canceling FHA MIP

If you put down 10% or more, the annual MIP can be cancelled after 11 years if you have a loan with a down payment of 10% or more. However, unlike conventional loans, FHA loans with a down payment of less than 10 percent require annual MIP payments for the life of the loan. If you belong to the latter group, the only way to eliminate MIP payments is to refinance into a conventional loan as soon as your LTV ratio qualifies you for a conventional mortgage without PMI.

The Bottom Line

If you do not have a substantial amount of cash saved for a down payment, you will incur PMI costs in order to borrow more money. If you choose this path, you're not alone. These days, the majority of homebuyers put down less than 20%. According to a survey by the National Association of Realtors, in 2021, the median down payment for repeat buyers was 17% and for first-time buyers it was 7%.

As you apply for mortgages, carefully compare loan estimates to determine how much you will pay for PMI. A loan that may not require private mortgage insurance but has a higher interest rate. If you need a loan with a low down payment, PMI is difficult to avoid with few exceptions, but there is a light at the end of the tunnel: but not to pay PMI for the life of the loan.