What is private mortgage insurance? PMI defined and explained

If you take out a conventional loan to buy a home with a down payment that’s less than 20% the purchase price, you’ll need to pay for private mortgage insurance. PMI reimburses your lender if you default on your mortgage payments. While you can’t opt out of paying for PMI on a conventional loan without a larger down payment, knowing how it works can help you better manage your payments and understand when you can cancel it.

Key takeaways:

• PMI protects your mortgage lender from losses if the borrower defaults on a conventional loan.
• PMI typically costs 0.5% to 1.5% of your total loan amount annually, but can vary based on your credit score, down payment size, and loan type.
• You can ask your lender to cancel your PMI payments once you reach 20% equity in your home. Your lender automatically cancels it when you reach 22% equity.

What is PMI?

What is private mortgage insurance used for? PMI protects your lender if you stop making mortgage payments and default on your mortgage. PMI is required for borrowers with a conventional loan and less than 20% home equity. Borrowers with a smaller down payment are riskier for lenders, and PMI mitigates that risk.

PMI applies only to conventional loans. Other types of loans charge their own types of mortgage insurance. For example, FHA loans require mortgage insurance premiums (MIP).

When is PMI required?

PMI is required when a borrower gets a conventional loan and puts down less than 20% of the purchase price.

For example, if you buy a home for $400,000 with a conventional loan, you’d need a down payment of at least $80,000 to avoid paying PMI. If you make a smaller down payment, you will pay for PMI until you have 20% equity. Lenders usually cancel PMI automatically once you’ve paid down your balance enough to reach 22% home equity.

If your home's value increases enough to reach 20% equity, you can refinance to eliminate PMI, though you would have to pay closing costs.

What is PMI used for?

When a borrower makes a smaller down payment, they start with less equity in their home. Lenders consider borrowers with a smaller stake in their home to be at higher risk of defaulting on their loans. If the borrower defaults and the home is foreclosed, the lender is less likely to recoup its losses by selling the home because of the high loan-to-value (LTV) ratio. PMI compensates the lender to cover those losses.  

How does PMI work?

The insurance policy is automatically added to your mortgage payment. You do not need to go out and shop for a PMI policy on your own. Your lender arranges the coverage through an approved private insurance provider.

How do I pay PMI?

For most homeowners, the annual PMI premium is divided by 12 and added to their mortgage payment. PMI is paid in addition to principal and interest, property taxes, and homeowners insurance, commonly referred to as PITI. You may have the option to pay your entire PMI premium up front as a lump sum at closing, or as a mix of a partial up-front payment and a smaller ongoing monthly fee.

Types of PMI

There are two main types of PMI.

Borrower-paid PMI

Borrower-paid PMI is the most common type. The borrower pays for this policy with a fee added to their monthly mortgage payment. The policy protects the lender against losses if the borrower defaults.

Lender-paid PMI

Lender-paid PMI is when the lender pays for the policy at closing, and you accept a higher mortgage interest rate in return. Unlike borrower-paid PMI, you can’t cancel lender-paid PMI when your equity hits 20% because it’s paid in full up front. The only way to reduce your mortgage payment with lender-paid PMI is refinancing to a lower interest rate.¹

How much is PMI?

You can typically expect PMI to cost 0.5% – 1% of your loan amount each year. The total you owe is typically recalculated each year, so your PMI payments should decrease a bit each year.

The exact cost of PMI coverage can vary depending on the following factors:

• Down payment size
• Credit score
• Interest rate
• Type of loan
• Loan-to-value ratio

How much is PMI on a $300,000 mortgage?

Suppose you buy a home for $300,000. You put down 5%, which equals $15,000, leaving you with a total mortgage balance of $285,000.

• If your lender determines that your annual PMI rate is 0.5%, your total annual PMI cost will be $1,425. When divided by 12 months, your monthly PMI payment is $118.75.
• If your annual PMI rate is 1.0%, your total annual PMI cost will be $2,850. Your monthly PMI payment is exactly $237.50.
• If your annual PMI rate is 1.5%, your total annual PMI cost will be $4,275. Your monthly PMI payment is roughly $356.25.

Again, the amount would be recalculated each year using your mortgage balance.

Factors that influence the cost of PMI

Your lender also will consider several different factors when determining how much PMI you'll have to pay.

Down payment amount

The size of your down payment determines how much you’ll pay for PMI. A smaller down payment represents higher risk for the lender, meaning the lender stands to lose a larger investment if you default and your home goes into foreclosure. As a result of the increased risk, you’ll likely have to pay more for PMI.

A lower down payment also means your regular mortgage payments will be higher, and it will take longer before you’re able to cancel PMI. Even if you can’t afford a down payment of 20%, increasing your down payment can reduce the amount of PMI you’ll have to pay.

Credit history

Your lender also will review your credit history to assess your borrowing habits. A higher credit score indicates that:

• You don’t borrow more than you can pay back.
• You pay your bills on time.
• You avoid maxing out your credit limit.

A lender may charge you a lower PMI premium if you have a solid credit history and a high credit score. If you have a lower credit score, your lender may have less faith in your ability to manage your debt responsibly and charge you a higher rate for PMI.

Loan type

Your loan type also influences how much you’ll have to pay in PMI. For example, fixed-rate mortgages can reduce the risk of default because the mortgage interest rate and your monthly payment won’t change. Less risk can mean you might not need to pay as much for PMI.

Adjustable-rate mortgages (ARMs) have interest rates that can go up or down based on market conditions. As a result, ARMs carry more risk because it is harder to predict your future mortgage payment. However, because ARMs also typically have lower initial interest rates than fixed-rate mortgages, you may be able to pay more toward your principal, build equity faster, and stop paying for PMI sooner.

LTV

Your LTV directly affects your insurance cost. The LTV compares the size of your loan with your home’s appraised value. If you buy a $100,000 home and borrow $90,000, your LTV is 90%.

Your LTV is the inverse of your down payment. A higher LTV indicates that you have less equity in the property, which increases the lender's risk and subsequently raises your PMI rate. As you pay down your mortgage over time, your LTV decreases.

Pros and cons of PMI

Consider the pros and cons of paying for PMI when you get a conventional mortgage.

Benefits of PMI

Some of the upsides of paying for PMI include:

• You can make a down payment as low as 3%² for a conventional loan.
• You can own a home sooner.
• You can begin building equity.
• You can cash on hand instead of making a larger down payment.
• PMI can be canceled once you hit 20% equity.

Drawbacks of PMI

There are also clear downsides of PMI, including:

• A higher monthly payment.
• Larger overall mortgage costs.
• Coverage protects the lender, not the client.
• Lenders won’t automatically cancel your PMI until you hit 22% equity.

How to avoid or reduce PMI

With all the other costs that come with your mortgage, it's certainly understandable why you might want to avoid the added cost of PMI. Luckily, it's possible to avoid paying for it – or at least pay less.

Make a larger down payment

The most straightforward way to avoid PMI is to make a 20% down payment on a conventional loan. If saving 20% isn't feasible, putting down 10% or 15% will significantly reduce your monthly PMI premium compared to a 3% down payment. You can experiment with a down payment calculator to see how different cash amounts affect your costs.

Take out an FHA or USDA loan

Is private mortgage insurance required with all types of mortgages? No. FHA loans do not require PMI, but it’s important to note that these government-backed programs do not actually help you avoid mortgage insurance or guarantee fees. Instead, they charge their own mandatory government premiums. In many cases, especially if your credit is strong, examining MIP vs. PMI may reveal that a conventional loan with PMI might be cheaper overall than an FHA loan with MIP.

Take out a VA loan

If you’re looking for mortgage loans with no mortgage insurance, there are VA loans.³ However, you must be an eligible military service member, veteran, or qualifying surviving spouse to obtain a VA loan. Not only do VA loans not require mortgage insurance, but they also don’t require a down payment. You will, however, need to pay the one-time VA funding fee.

Take out a piggyback loan

Another strategy to avoid PMI is to use a piggyback loan. For example, let's say you can only afford to make a 10% down payment, but you don't want to pay for PMI. You could get a piggyback loan to cover the additional 10%, bringing your down payment to 20%.

A piggyback loan can help you avoid PMI, but you’ll have to make payments on a second mortgage. Not only will you have two payments, but the rate on the second mortgage will be higher because your primary mortgage gets paid first if you default.

If you can’t keep up with the payments on both mortgages, you can lose your home. A piggyback loan is an added financial burden, so be sure to do the math and determine whether you’re saving money or if it just makes sense to pay for PMI.

How to get rid of PMI if you already have it

Here is how to get rid of PMI and save money. You have the legal right to request that your lender cancel your PMI once your outstanding mortgage balance drops to 80% of the home's original appraised value or its original purchase price.

If you’re paying PMI on a conventional loan, ask your lender how to cancel it once you’ve reached 20% equity. If you're a Rocket Mortgage client, call (800) 4-ROCKET.

For your lender to honor your request to cancel mortgage insurance, you must be current on your mortgage payments, and an appraisal must verify the current property value.

FAQ

Here are answers to some common questions about PMI.

Is it better to pay PMI or put 20% down?

It depends on your financial situation and goals. Putting 20% down is better if you want to avoid the extra monthly fee and save money over the life of the loan. However, if saving 20% will take you 5 extra years, paying PMI allows you to buy a home today, build equity, and avoid rising rent prices. For many, the trade-off of paying PMI to buy sooner is worth the cost.    

What is PMI, and why is it bad?

PMI is an insurance policy that protects the lender if you default on your conventional loan. It is not inherently bad – it helps many people buy a home with a smaller down payment. However, borrowers often view it negatively because it increases their monthly housing costs while protecting the bank rather than the homeowner.

Why do I have to pay for PMI?

You must pay for PMI because putting down less than 20% of the purchase price makes your loan statistically riskier for the bank. The insurance premium helps the lender recoup its losses if you stop making your mortgage payments.

Who do I call with questions about PMI?

If you have questions about your specific PMI premium, how to pay it, or the exact steps required for cancellation, call your current mortgage servicer or lender. They have access to your specific loan file and can tell you exactly when you will reach the 20% or 22% equity thresholds.

The bottom line

PMI protects your lender and allows you to purchase a home with a conventional loan and a down payment of less than 20%. While it does add to your monthly payment and overall loan cost, it also lets you start building home equity today rather than waiting years to save for a large down payment. When you’re shopping for a home, ask your lender how they handle mortgage insurance and how much you could expect to pay in PMI.

Are you ready to begin the home buying process? If so, start your mortgage application online with Rocket Mortgage today.

¹Refinancing may increase finance charges over the life of the loan.

²The 3% down payment option is only available on certain conventional loan products and is not available in all states. Additional terms and conditions may apply.

³Rocket Mortgage is a VA-approved lender, not endorsed or sponsored by the Dept. of Veterans Affairs or any government agency.