What is private mortgage insurance (PMI)?

Most home buyers will generally borrow more than 80% of a home's purchase price to finance the purchase.  To protect the lender, the home buyer will be required to pay for an insurance policy for the lender that reduces the risk of a potential loss in the case of foreclosure.  This insurance is known as private mortgage insurance (PMI).

Though a home buyer may scoff at the idea of paying insurance for the lender that has no direct benefit for him/her, the reality is that mortgage insurance allows a home buyer to:

1) Become a home owner sooner.  To buy a home without mortgage insurance, the home buyer will generally need to make a 20% or greater down payment on the home.  If the sales price is $100,000, for example, the home buyer will need $20,000 to purchase the home.  Mortgage insurance, on the other hand, allows the same home owner to purchase that home with as little as 3% or $3,000 in this example.

2) Increase the home buyer's purchasing power.  Mortgage insurance allows a home buyer to purchase more home.  Assume a young couple has saved $10,000 for the purchase of a home.  Without mortgage insurance, their $10,000 down payment would only allow them to purchase a $50,000 property ($50,000 x 20% = $10,000).  On the other hand, mortgage insurance gives the young couple more options.  They could make a 10% down payment on a $100,000 home ($100,000 x 10% = $10,000) or even make a 5% down payment and use the remaining 5% for decorating, investing, or take a vacation.

3)  Gain tax advantages.  By making smaller down payments, a borrower may gain tax advantages because he/she will have more deductible interest to claim.

This should not be confused with other forms of insurance.  Hazard insurance is designed to protect the home owner from any loss due to specified hazards such as a fire.  Home owner's insurance protects a the owner if the house and/or its contents suffer from unforeseen occurrences such as weather damage or theft.  Mortgage life insurance is an insurance policy that provides financial protection for the home owner and/or his/her family in the case of the home owner's death.

The cost of private mortgage insurance will depend upon the percentage of down payment and the type of loan.  Most home buyers will pay approximately 7/10th of 1% of the loan amount for mortgage insurance (on a $100,000 loan, that equates to approximately $65.00 per month for mortgage insurance).