What is Private Mortgage Insurance (PMI)?

Private Mortgage Insurance (PMI) is essentially foreclosure insurance.  It protects the mortgage lender from taking a financial loss on minimum-down loans if they are forced to foreclose on your home and sell the property at auction.

When you make a large down payment on a home, there is a lot of "equity" (the difference between the home's value and the mortgage balance).  That means the lender is virtually guaranteed to recover all of their money if they are forced to sell your home at a foreclosure auction.

But if you make a down payment of only 5% of the purchase price, you have very little equity in the property and the lender is likely to suffer a financial loss in the event of a foreclosure because homes typically sell for far less than full market value at forced sale auctions.  

That's why if you make a down payment of 20% or more, you will not be required to purchase PMI to cover the lender's risk.  But if you make a down payment of less than 20%, you will be required to pay for PMI.   The PMI insurance rate is based on a sliding scale.  The smaller your down payment, the higher the PMI rate.  For example, if you are getting a $150,000 mortgage with 15% down payment, the PMI rate would be about $40 per month.  If your down payment was 10%, the PMI rate for the same loan amount would be about $65 per month.  And if your down payment were only 5%, the PMI rate for that loan amount would be about $98 per month.

So you can see, that if you have the cash available, it is usually best to make a down payment of at least 20% of the purchase price in order to avoid paying PMI.

However, be aware that you do not have to PMI forever.  If you make all your mortgage payments on time for at least two years, and your property appreciates to a point where your mortgage loan balance is equal to 80% or less of the home's current market value, you can ask the lender to drop the PMI insurance coverage.  For example, if you bought a $200,000 house with a 5% down payment, your loan amount would be $190,000.  After two years, your loan balance would be down to about $186,500.  If your home had increased in value to $235,000, your "loan-to-value" (LTV) ratio would be 79.36% ($186,500/$235,000).  That means you would be below the 80% LTV level and eligible to ask your lender to drop your PMI coverage.

Typically, you would be required to pay for an appraisal to verify the current market value of your home.  An appraisal may cost $200 to $400, but it is only a one-time cost, and well worth it when you consider how much money you will save each month by eliminating your PMI payment. 

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