Private Mortgage Insurance (PMI)
Private Mortgage Insurance, commonly known as PMI, is a specific type of insurance policy required by lenders for conventional home loans when the borrower makes a down payment of less than 20% of the property’s purchase price. This insurance serves as a risk management tool for the lender, providing financial protection if the borrower defaults on their mortgage obligations.
It is essential to understand that PMI protects the lender, not the borrower. While the borrower pays the premiums, the policy’s beneficiary is the financial institution that issued the loan.
Purpose and Function
The primary purpose of PMI is to mitigate the lender’s risk when issuing a loan with a low down payment. A smaller down payment means the borrower has less equity invested in the property, which statistically correlates with a higher likelihood of default. Should the borrower stop making payments and the property enter foreclosure, PMI reimburses the lender for a portion of their financial losses.
By transferring this risk to an insurance company, PMI allows lenders to offer mortgages to a wider range of buyers who may not have the resources for a 20% down payment, thereby expanding access to homeownership.
How It Works
PMI is typically paid as a monthly premium that is added to the borrower’s total mortgage payment (PITI). The premium costs vary based on several factors, including the loan amount, the borrower’s credit score, and the size of the down payment. A lower down payment and a lower credit score will generally result in a higher PMI premium.
In some cases, lenders may offer alternatives to monthly PMI, such as:
- Single-Premium PMI: The borrower pays the entire insurance premium as a lump sum at closing.
- Lender-Paid PMI (LPMI): The lender covers the cost of the insurance in exchange for charging the borrower a slightly higher interest rate over the life of the loan.
Removal of PMI
One of the key features of PMI on a conventional loan is that it is not permanent. Homeowners have several pathways to remove this extra cost:
- Automatic Termination: The Homeowners Protection Act of 1998 mandates lenders automatically terminate PMI when the loan’s principal balance is scheduled to reach 78% of the original property value, provided the borrower is current on their payments.
- Borrower-Requested Cancellation: A homeowner can formally request their lender cancel PMI once the mortgage balance reaches 80% of the home’s original value. This can be achieved through regular principal payments or by making extra payments to accelerate the reduction of the loan balance.
- Reappraisal: If the property’s value has significantly appreciated, a homeowner can pay for a new appraisal. If the new appraisal shows the loan-to-value (LTV) ratio has fallen to 80% or less due to market appreciation and principal pay down, the homeowner can request PMI cancellation based on the current value.
By strategically managing their loan balance and staying aware of their property’s value, homeowners can eliminate this additional monthly expense and reduce their housing costs.
