PMI: What Does It Really Do?

As a homeowner, you probably are all too aware of the amount of that monthly payment. You might not, however, be aware of that breakdown of that lump sum payment until you review the year-end statement from you lender. If you've noticed it at all, you probably simply note an amount that is designated PMI.

What is it? What is it for? Why am I paying this? If you have ever asked those questions, you may also realize that PMI is a required part of most conventional mortgage payments.

What is PMI?

Private Mortgage Insurance (PMI) is an insurance paid by the borrower to protect the lender against default. If you have a conventional or FHA loan and paid less than 20 percent on the down payment, it's likely that you pay a premium each month to maintain an insurance policy that will help your lender in case you can't afford to pay your mortgage at some point in the future.

Ways to Avoid PMI

It's possible to avoid paying PMI, but it requires more planning and saving on behalf of the buyer before the house is purchased. General guidelines for PMI are that it can be waived if the buyer has at least 20 percent equity in the property. The rules are somewhat different for FHA loans, and some require mortgage insurance for the life of the loan.

In reality, that means that if you make an initial down payment of 20 percent or more, you will never have to pay private mortgage insurance. As you make your monthly payments and chalk up yearly totals in the principal column, the lender is required to eliminate PMI when you have paid an amount equivalent to 22 percent of of the total loan, usually described as when your equity reaches 78 percent of value.

It's difficult to estimate how long that might be, however, because not only do down payments vary but the rate charged for PMI also is variable.

Pros and Cons of a Larger Down Payment

The norm for the past couple of decades has been to put as little down as possible. But before you automatically opt for a small down payment, you might want to do some serious financial calculations.

As a general rule, you can figure that the rate for PMI will be somewhere between one-half and one percent of the loan amount on an annual basis. For every $200,000 you borrow for your Fort Hunt home, you'll pay between $1-2,000 a year to protect your lender.

Is it worth it? Only you can decide. But here are some things to consider:

• It takes years to build equity through monthly payments, especially in the early years, because most of the total is applied to interest rather than principal.
• For every $100,000 of mortgage loan, you could be paying up to about $90 a month for PMI. Over a five-year period, that could equal some nice vacations, or even a new car.
• Depending on your income level, the PMI you pay might not be tax deductible under current IRS rules.
• Depending on your lender's "fine print," you may be obligated to pay PMI for a specified number of months, and it might be difficult to actually cancel. Sometimes, documentation of value or a new appraisal are required, adding time and cost to the process.
• At some point, particularly if property is appreciating rapidly, you might consider refinancing your home. Depending on current value, your equity position could be high enough that PMI would not be required.

Deciding to buy a home requires weighing option. PMI may be just one of those options.