What is Private Mortgage Insurance (PMI) and How Does It Apply to Conventional Loans?
Dreaming of owning your own home? That's awesome! But navigating the world of mortgages can feel like learning a new language. Don't worry, we're here to help! Ever heard of PMI? It's one of those terms that can sound a little intimidating, but it's actually pretty straightforward once you understand it.
PMI, or Private Mortgage Insurance, is basically an insurance policy that protects your lender. It's there in case you can't make your mortgage payments. Think of it as a safety net for the bank or mortgage company.
The reason it exists is because when you put down less than 20% on a home, the lender is taking on a bit more risk. PMI helps to offset that risk.
You'll most often hear about PMI in the context of conventional loans, which we'll dive into shortly. There are other types of mortgage insurance out there, but for now, we're focusing on PMI and how it relates to these types of loans.
PMI isn't all bad! It can actually make homeownership possible sooner for many people. But there are also some downsides to be aware of. We'll weigh the pros and cons so you can make an informed decision.
1. What is Private Mortgage Insurance (PMI)?
Definition: What Does PMI Actually Do?
Private Mortgage Insurance (PMI) is a type of insurance that lenders require when a homebuyer puts down less than 20% on a conventional loan. The key thing to remember is that PMI does not protect you as the borrower—it protects the lender in case you stop making payments on your mortgage.
Even though PMI adds an extra cost to your monthly mortgage bill, it’s what allows many buyers to purchase a home with as little as 3% to 5% down. Without it, lenders would see low-down-payment loans as too risky and might not offer them at all.
Why Does PMI Exist?
Lenders take on more risk when they approve a loan with a small down payment. That’s because when a borrower has less equity in the home, they’re more likely to default (miss payments) in tough financial situations. PMI helps offset this risk by providing a safety net for lenders if a borrower stops making payments.
This is where the Loan-to-Value (LTV) ratio comes in.
The LTV ratio is a percentage that shows how much of the home's value is covered by the mortgage versus how much is covered by your down payment.
The higher the LTV (meaning the lower your down payment), the riskier the loan is for the lender.
PMI is typically required when your LTV is above 80%, meaning you’ve put down less than 20% of the home’s purchase price.
PMI vs. Other Types of Mortgage Insurance
It’s easy to confuse PMI with other types of mortgage insurance, so let’s clear that up:
PMI (Private Mortgage Insurance): Only applies to conventional loans and is typically paid monthly. It can be removed once you reach a certain level of equity.
MIP (Mortgage Insurance Premium): Applies to FHA loans and typically lasts for the life of the loan unless a large down payment is made.
VA Loans and USDA Loans: These government-backed loans don’t require PMI but may have other upfront or ongoing fees instead.
For this blog, we’re focusing on PMI for conventional loans, since it’s the most common type borrowers encounter when going this route.
2. Conventional Loans and the 20% Down Payment Threshold
What is a Conventional Loan?
A conventional loan is a mortgage that isn’t backed by a government agency like the FHA, VA, or USDA. Instead, these loans follow guidelines set by Fannie Mae and Freddie Mac, two major entities in the mortgage industry.
Conventional loans are popular because they offer flexibility, competitive interest rates, and the ability to avoid long-term mortgage insurance—if you can meet the 20% down payment threshold.
The Significance of the 20% Down Payment
You’ve probably heard that putting 20% down is the magic number to avoid PMI. But why is that?
Lower Risk for Lenders: A higher down payment means the lender is financing less of the home’s value, reducing their risk if you stop making payments.
More Equity for You: The more money you put down upfront, the more ownership (equity) you have in the home from day one.
Lower Monthly Payments: With a bigger down payment, you borrow less, leading to smaller monthly mortgage payments.
Why 20%?
This number isn’t random—it’s based on historical data and risk calculations used by lenders. When a borrower puts down 20%, it provides a comfortable equity cushion, meaning there’s less chance of the lender losing money if the home needs to be sold due to foreclosure.
However, not everyone can afford to put down 20%, especially first-time homebuyers. That’s where PMI comes into play, allowing buyers to enter the market sooner instead of waiting years to save a large down payment.
3. How PMI Works on Conventional Loans
If you’re using a conventional loan and putting down less than 20%, PMI will likely be part of your mortgage payment. But how exactly is PMI calculated, and how do you pay for it? Let’s break it down.
PMI Premiums: How They Are Calculated
The cost of PMI isn’t one-size-fits-all—it depends on several factors, including:
Credit Score: Borrowers with higher credit scores typically pay lower PMI rates.
Down Payment Size: The larger your down payment, the lower your PMI cost.
Loan Type & Term: A 15-year mortgage may have lower PMI costs compared to a 30-year loan.
Loan Amount: The more you borrow, the more PMI will cost.
On average, PMI can range from 0.3% to 1.5% of the loan amount per year. That means if you take out a $300,000 loan, your PMI could be anywhere from $900 to $4,500 annually, or $75 to $375 per month.
Different Ways to Pay PMI
PMI doesn’t always work the same way for every borrower. Here are the most common options:
Monthly PMI (Most Common)
Added to your mortgage payment each month.
No large upfront costs, making it easier for buyers with limited savings.
PMI disappears once you reach 80% loan-to-value (LTV) and request removal.
Example: If your PMI rate is 0.5% on a $250,000 loan, you’ll pay about $104 per month in PMI.
Upfront PMI
Paid in a lump sum at closing.
Eliminates the monthly PMI charge, lowering your mortgage payment.
Risk: If you sell or refinance early, you won’t get a refund on the upfront cost.
Example: A 1% upfront PMI fee on a $250,000 loan would require a $2,500 payment at closing.
Lender-Paid PMI (LPMI)
The lender pays your PMI, but you’ll get a higher interest rate in return.
No separate PMI payment, but you’ll pay more over the life of the loan.
Can be beneficial if you plan to stay in the home for a long time.
Example: Instead of a 6.5% interest rate with PMI, you might have a 6.875% rate with LPMI.
Split PMI (Combination of Upfront & Monthly Payments)
Pay part of PMI upfront and reduce monthly costs.
Good middle ground for those with extra cash at closing but don’t want a large lump sum payment.
4. Getting Rid of PMI on a Conventional Loan
The good news? PMI doesn’t last forever! Here’s how you can remove it:
Automatic PMI Termination (The 78% Rule)
By law, lenders must automatically remove PMI once your loan balance reaches 78% of the original home value—as long as you’re current on payments.
No action required from you! The lender will cancel it automatically.
This process is based on the original purchase price, not the home’s current value.
Requesting PMI Removal (The 80% Rule)
You don’t have to wait for automatic cancellation! Once your loan balance reaches 80% of the home’s original value, you can request PMI removal early.
What’s required?
A written request to your lender.
A good payment history (no recent late payments).
Your home’s value must not have declined. Some lenders may require an appraisal.
Example: If you bought a $300,000 home and paid down your loan to $240,000, you can request PMI removal.
Refinancing to Remove PMI
If home prices have gone up, you may be able to refinance into a new loan without PMI.
Works best if your home’s value has increased significantly.
Can also help if you’ve improved your credit and can qualify for a better rate.
Example: If you bought a home for $250,000 with 10% down, but its value has risen to $300,000, your LTV may already be below 80%—allowing you to refinance and ditch PMI.
5. Alternatives to PMI
If you want to avoid PMI altogether, here are some other options to consider:
Piggyback Loans (80/10/10 Loans)
Instead of one loan with PMI, you take out two loans:
80% first mortgage
10% second mortgage (home equity loan or HELOC)
10% down payment
Pros: No PMI! Can be helpful for borrowers with strong credit.
Cons: The second mortgage often has a higher interest rate and additional monthly payments.
Larger Down Payment
If you can save 20%, you’ll avoid PMI completely.
Less money borrowed = lower monthly payments and interest costs.
Of course, saving a large down payment isn’t easy, especially for first-time buyers.
Consider Other Loan Types
FHA Loans: Require Mortgage Insurance Premium (MIP), which is different from PMI but lasts longer in most cases.
VA Loans: No PMI required for eligible military service members and veterans.
USDA Loans: No PMI, but they have their own mortgage insurance fees.
6. Common Misconceptions About PMI
There are a lot of myths floating around about PMI—let’s clear some of them up!
“PMI is tax-deductible.”
It was tax-deductible in some years, but tax laws change. Check with a tax professional for the latest rules.
“PMI protects me if I can’t make my mortgage payments.”
Nope! PMI only protects the lender. If you fall behind on payments, PMI doesn’t help you avoid foreclosure.
“PMI automatically goes away once I pay off 20% of my loan.”
Not quite! PMI must be requested at 80% LTV—if you wait, it will cancel automatically at 78% LTV.
FINAL THOUGHTS
Okay, let's wrap things up...
PMI is a type of insurance that protects your lender if you default on your conventional loan. It's usually required when you put down less than 20%. While it adds to your monthly expenses, it can make homeownership possible sooner. You can get rid of PMI once you reach a certain equity level.
Understanding PMI is a crucial part of the home-buying process. It's important to know how it works, how it affects your payments, and how you can eventually get rid of it.
This article is a great starting point, but every situation is unique. It's always a good idea to talk to a qualified mortgage professional who can assess your individual circumstances and provide personalized advice. They can help you determine if a conventional loan with PMI is the right option for you.
At The Next Chapter Mortgage, our dedicated mortgage advisors are ready to guide you through the approval process with personalized support. We understand that navigating the complexities of buying a home can be overwhelming, and we're committed to making it easier for you.
We invite you to reach out to us to explore your options and see if a Conventional Loan is a good fit for you. We're excited to help you take this important step toward homeownership!
