What is Private Mortgage Insurance (PMI)?

Private mortgage insurance, or PMI, protects lenders against losses that result from defaults on home mortgages. Homebuyers who put down less than 20 percent of the purchase price are required to buy PMI for their entire mortgage loan. Without private mortgage insurance, many people would struggle to afford a home because traditional homeowners insurance does not cover their mortgage.

How PMI works

An insurance company issues you a PMI policy, which entitles you to coverage if the primary borrower defaults on your loan. The premiums for private mortgage insurance are based on your down payment and credit score. Typically, the higher the credit score, the lower the premium.

Benefits of PMI

Lenders typically require private mortgage insurance when homebuyers make down payments below 20 percent. But there are several benefits to this type of insurance. For one, PMI protects your lender against default so you can keep your home if you run into financial problems. It also protects your credit score. Being current on your mortgage helps you keep up with other debts and can boost your credit score. Private mortgage insurance is tax deductible.

The cost of PMI

The cost of private mortgage insurance varies between lenders, but expect to pay an annual premium based on your loan amount and credit score. The average cost for homeowners with good credit is about 0.5% of the original balance annually, although payments are typically broken into monthly installments. That works out to $500 for every $100,000 you borrow.

Drawbacks of PMI

PMI can be costly. If you put less than 20 percent down when purchasing your home, private mortgage insurance is probably unavoidable. PMI will be part of your monthly payment until you've built up 20 percent equity in your home, which could take several years or longer depending on the market trends. If you lose your job or suffer another setback that prevents you from making your monthly payments, you could lose the home if you don't have enough equity.

You can get rid of private mortgage insurance when you are about two-thirds finished paying off your loan. At that point, your lender will require you to pay off a portion of your loan balance every month until the total reaches 80 percent of your home's original appraised value. When the balance reaches 80%, you will no longer require this insurance.

You could lose money when refinancing or selling your home if you have not paid down the principal on your mortgage enough to cover the remaining private mortgage insurance premiums. The result is that you must continue to pay for PMI for a longer period of time.

Not everyone qualifies for PMI. Depending on your financial situation, you may not qualify for PMI in the first place or it may cost more than what you can afford. Your credit score could be too low, which means you will pay more because the insurance company takes on additional risk when insuring your loan.

Alternatives to PMI

For many homebuyers, avoiding PMI means saving up a bigger down payment and taking out a smaller loan. But there are other alternatives:

1. You can ask your bank about getting rid of private mortgage insurance by refinancing your mortgage with another lender once you build up enough equity in your home.
2. You can try to negotiate the terms of your loan with the lender - perhaps, for example, you could reduce your required down payment or change from a 30-year fixed-rate mortgage to an adjustable-rate mortgage.
3. Consider buying a less expensive house – otherwise known as "buying down."
4. You can apply for a grant from the U.S. Department of Housing and Urban Development that helps low-income families pay their mortgage insurance premiums.
5. You could also look into buying a multi-unit property, such as a duplex or triplex, which typically carries lower rates because there are multiple units in the building and the lender gets a bigger share of rental income.