While purchasing a house increases your chances of long term capital appreciation, accumulating enough capital for a down Payment is the challenge. Getting a Mortgage with a lower than average down payment is possible, but the lender may require you to get Private Mortgage Insurance (PMI). 

This solution allows you to secure a mortgage with a reduced down payment. The trade-off is that you will have to pay extra money until you achieve a certain percentage of equity in your home. 

Buyers who use a low down payment mortgage are not locked into paying mortgage insurance premiums for the entire loan term. Proper planning and budgeting can empower you to eliminate PMI from your monthly payment. 

To give buyers an idea of how PMI might affect their homebuying journey, the team at Prevu Real Estate put together a guide to demystify private mortgage insurance.

What is private mortgage insurance (PMI)? 

Private mortgage Insurance is a financial safeguard for lenders when a homebuyer makes a down payment less than 20% of the purchase price of a home. The idea is that this insurance protects the lender in case a buyer defaults on a conventional loan. 

PMI can be a separate policy or escrowed as part of the monthly mortgage payment, with the cost varying based on factors like the loan amount and credit score. It's important to know that PMI benefits the lender and adds an extra cost for the borrower. However, when the borrower's equity in the home reaches 20% or more, they can request PMI removal.

Lenders usually require 20% of the purchase price of the home at closing as a down payment to minimize risk on a conventional home loan. Lenders want borrowers to pay 20% of the price as it gives buyers equity in the home. But if a buyer has limited capital, lenders will permit them to make a lower down payment, so long as they get private mortgage insurance.

When you pay PMI premiums, it is protecting the lender who is providing you a mortgage with much less money down at closing. When buyers pay the normal 20% down payment, that puts a level of equity into the homeowner’s hands. But when you use a mortgage with a lower down payment, lenders need extra security from a default, via the mortgage insurance. 

Why would you use private mortgage insurance? 

There are many reasons to utilize a loan that offers a chance at a lower down payment. 

A reduced down payment means buyers can conserve their savings when purchasing a home. Using a mortgage with PMI means new homeowners have money ready for home improvements, remodeling jobs, furnishing the house, and even saving for emergencies. 

Yet it is hard to deny that the biggest boon of PMI is helping buyers get into the housing market sooner rather than later. 

How do you get PMI?

Once you have chosen a lender and decided to use a conventional loan with a lower down payment, you must apply for private mortgage insurance. 

The lender will want to know your financial situation, employment history, and creditworthiness. After reviewing your application, the lender will determine if you meet their PMI requirements. If approved, they will include PMI as part of your loan. 

How much does PMI cost? 

The cost of your PMI will range depending on the purchase price of your home. Generally, this amounts to a few thousand dollars a year, which get broken down into your monthly mortgage payments. 

The cost of PMI is determined by several factors, including the loan-to-value (LTV) ratio, which is the ratio of the loan amount to the appraised value of the home. A higher LTV ratio indicates a lower down payment and higher perceived risk, leading to a higher PMI premium. 

So the final amount charged depends on the size of the loan, your credit score, and what your actual down payment is. You can find loan programs with reduced premiums, but you should expect PMI costs to range from 0.3% to 1.5% of the original loan amount per year. 

Say you purchase a home for $400,000 and put down $20,000. That is 5% of the purchase price and you have to borrow the remaining 95% for a loan amount of $380,000. If the PMI is 1% of the purchase price of the home, you can expect to pay about $4,000 a year in PMI, which comes out to $333.34 each month. 

When do you pay for private mortgage insurance? 

The premium for PMI is typically collected in a borrower’s monthly payment in addition to the principal, interest, taxes, and hazard  insurance (PITI) aspects of their monthly mortgage payment. 

It's essential for buyers to be aware of the PMI premium and factor it into their budget when determining their overall affordability for a property and how much they can afford in monthly payments.

When does PMI end? 

There are several ways you can end your private mortgage insurance payments based on certain conditions being met.

The most common way is to reach a specific level of equity, typically 20% equity in your home. If you can reduce the outstanding balance on the loan to 80% or less of the home's appraised value, you can reach out to your lender to cancel or terminate the PMI. 

You will want to monitor your home equity and maintain contact with your lender so you can cancel the PMI once you reach this 80% loan-to-value threshold. Lenders may have specific procedures and requirements for PMI cancellation, which borrowers should be aware of and follow accordingly.

However, there are other scenarios where PMI may be automatically terminated, such as FHA loans, where mortgage insurance is required for only a set period of time.

Understanding PMI cancellation and termination 

Canceling PMI can vary depending on the loan program, lender, and specific circumstances. But generally, once you reach 80% loan-to-value, you can start the process. 

Typically, buyers must provide proof of home value, payment history, and evidence of additional principal payments made. Sometimes, lenders even require a new appraisal to verify the property's current value.

When eligible, ensure you proactively monitor your home equity and start the PMI cancellation process. It does not hurt to have a third-party appraisal done when you believe you’ve achieved greater than 20% equity in your home, but be sure to speak with your lender about the appraisal requirements before you pay twice for an appraisal.

Do you need to pay PMI on all low down payment loans? 

The short answer is that you are only required to pay PMI on some low down payment loans. Yet there are instances where you could be using an adjustable-rate mortgage (ARM), and a lender usually charges a higher cost for private mortgage insurance than they would for a fixed-rate mortgage.

Beyond fixed-rate mortgages and ARMs, government-backed loan programs like Federal Housing Administration (FHA) and Veteran Affairs (VA) loans have different types of insurance mechanisms in place. FHA loans often require a minimum down payment of 3.5%, while VA loans can allow for as low as zero down payment for eligible veterans and active-duty service members.

When using an FHA, the borrower must pay an upfront mortgage insurance premium (UFMIP) at closing and an annual mortgage insurance premium (MIP) added to the monthly payments. Buyers can choose to fund the UFMIP cost by increasing the loan amount.

VA loans do not require monthly mortgage insurance premiums like PMI or MIP. Instead, the VA requires a funding fee, which can be a one-time upfront payment or financed into the loan. The funding fee, meanwhile, can depend on a person's military service category, the down payment percentage, and whether it's the borrower's first VA loan.

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