The Role of Private Mortgage Insurance (PMI)

How Does PMI Work and What Is Its Purpose?

PMI is arranged by your lender and designed to cover the costs they would incur if you, as a mortgage borrower, fail to make your monthly payments. It’s usually required if you try to buy a home with a down payment of less than 20% of the purchase price.

Remember, when you buy a home with a mortgage loan, the lender pays most of the upfront costs. So, if you were to stop paying without much equity built up, the lender could lose a lot of money.

PMI addresses this problem for mortgage lenders. Insurance companies offer it so the lender isn’t as financially damaged if a mortgage borrower suddenly stops paying their loan balance.

Note that PMI doesn’t give you — the borrower — insurance policy protection, and there is no PMI tax deduction. So, even if you have it, you can default on your home if you stop making payments towards your balance.

What Are the Types of PMI?

You may not get to decide whether to purchase private mortgage insurance, but lenders may let you select the type of insurance used throughout your loan term. This can impact when and how you pay PMI.

Here’s a look at four common types of PMI that may be an option for your home loan.

1. Single-Premium Mortgage Insurance (SPMI)

With SPMI, you pay your entire mortgage insurance premium upfront as part of your closing costs. This increases the amount you pay for the home today but decreases your monthly payments for the rest of the loan term (or at least until you can remove your PMI).

However, this option carries a risk. If you sell your home within a few years, you won’t get any part of the premium refunded. If you make a large insurance down payment, you could pay for years of PMI coverage without getting any value out of the policy.

Given that, you should probably only consider SPMI if you’re confident you’ll remain in the home you’ve bought for at least as long as the policy is designed to last.

2. Lender-Paid Mortgage Insurance (LPMI)

You might also get the option of LPMI. This sounds like the obvious choice in that it’s essentially lender-paid PMI. However, in practice, the mortgage company will usually pass the insurance policy costs to you.

They tend to do that by charging you a slightly higher interest rate over the course of your loan. The total amount you pay to cover PMI costs may be more or less than a borrower-paid policy. If you’re unsure, you can ask your lender if they have a PMI mortgage insurance calculator you can use to estimate PMI and find the best policy for your needs.

Since you typically pay PMI costs through a higher interest rate, you may be able to remove those costs down the line by refinancing your home. But there’s no guarantee you’ll be able to do that, and it may not be possible until your remaining mortgage balance is lower.

3. Borrower-Paid Mortgage Insurance (BPMI)

Next up is BPMI, which involves splitting your total premium into monthly payments and tacking those onto your mortgage. So, you might pay $2,200 per month instead of $2,000 to cover insurance policy costs.

This is the same way many of us pay for car insurance and other insurance policies. It’s convenient because you don’t have to pay as much cash upfront to get the necessary coverage. But you end up spending more on housing every month.

If you’re choosing between BPMI and SPMI, the better option will depend on your preferences. If you’d rather spread the costs out and pay them every month, BPMI makes more sense. But if you’d rather pay off your PMI upfront so you don’t have to worry about it later, SPMI would likely be a wiser choice.

4. Federal Home Loan Mortgage Protection or FHA Loans

The Federal Housing Administration (FHA) offers insurance for home loans. This allows lenders to offer better deals to qualifying homebuyers because the FHA pledges to pay the loan if the buyer defaults.

You don’t need to worry about PMI if you use an FHA loan to buy a home. However, the FHA replaces PMI with its own form of insurance, called a mortgage insurance premium (MIP). Like PMI, you can also pay your MIP costs upfront or spread them throughout the life of your loan.

FHA loans may allow you to qualify for a mortgage with a lower credit score and reduced down payment. But your loan term, closing costs, and other factors can impact whether it’s the right option for you.

How Does PMI Impact Monthly Mortgage Payments?

If you pay your entire PMI premium when closing on your home, you won’t have to worry about any further costs adding to your monthly mortgage payments. But if you choose to pay every month instead, PMI can cost between 0.22% and 2.25% of your mortgage annually.

Several factors can impact how much PMI coverage adds to your monthly mortgage payment. We talk about two important ones below.

Understanding Loan-To-Value Ratio

Lenders typically only require PMI if you put less than 20% down on the home you buy. But you don’t have to keep paying for PMI until you pay off your mortgage.

Thanks to the Homeowners Protection Act (HPA), you can ask your lender to cancel your PMI once you owe 80% or less of your home’s value. This brings us to loan-to-value (LTV) ratios and how they impact private mortgage insurance.

LTV is a measurement comparing the amount of mortgage you still need to pay off with the value of your property. For example, if you buy a $1 million home and pay $200,000 of it in principle, your LTV on the property would be 80%.

Once you reach an 80% LTV on your home, you can ask your lender to cancel your PMI coverage. When you reach a 78% LTV, the law says the lender must cancel your PMI coverage automatically.

The Role of Credit History in the Cost of PMI

Credit plays a significant role in determining your monthly PMI costs. Generally, your private mortgage insurance premium goes down the higher your score is, assuming the same down payment.

For example, a 2021 Urban Institute report found that annual PMI costs can range from 1.42% to 0.38% of your mortgage value (with a 5% down payment). The factor that determines where you land on that scale is your credit score.

When Can You Ask Your Mortgage Loan Services To Cancel PMI?

We touched on this previously, but it’s worth quickly reiterating. Once your home’s LTV reaches 80%, you can request your lender cancel your PMI coverage.

That process may require additional steps, such as a home value appraisal. However, the lender must legally cancel your coverage once you reach 80% LTV. And if you forget to ask, the lender must cancel it automatically when your LTV hits 78%.