Private Mortgage Insurance (PMI): What is it?

Private Mortgage Insurance is a term that many of us have often heard, but may have questioned its meaning or value. Private Mortgage Insurance (PMI) is an insurance product created to protect lenders from the risk of granting high "loan to value" (LTV) conventional loans; loans in which the Borrower's equity (cash) is less than 20% of the purchase price of the property.

PMI is an insurance policy the Lender acquires from a mortgage insurance company; however, the premiums are paid by the Borrower. It does not insure the loan in its entirety from the risk of default; only a portion is insured, usually 20 to 25%.

To better understand how a PMI policy works, let's say the purchase price of a property is $500,000 and the Buyer makes a 10% down payment. To calculate the insured amount of the loan:

1. Multiply 90% (aka "Loan to Value" or LTV) by 500,000 (purchase price) equals 450,000 (loan amount) then
2. Multiply 450,000 by 20% (mortgage insurance coverage) equals 90,000 (insured portion)

Therefore, the PMI policy coverage is $90,000 on this transaction. If the Borrower defaults on the mortgage or the mortgage is foreclosed, the mortgage insurance company retains the right to instruct the Lender to either sell the property and file a claim for reimbursement of the Lender's actual losses (if any) or relinquish the property to the mortgage insurance company and file a claim for actual losses. The claim amount cannot exceed the policy coverage. In this example, the Lender can make a claim for losses up to $90,000.

The Lender can claim a loss for unpaid interest, property taxes, hazard insurance, attorney's fees, expenses for maintenance and/or preserving the property during the resale or foreclosure process, and the selling costs involved in the selling of the property. In the example above, the Lender (at a minimum) has access to the owner's equity, $50,000 (10% down payment), plus the PMI policy amount, $90,000; totaling $140,000. If the Borrower in this example had made a 20% down payment, the Lender (at a minimum) would have access to the $100,000 equity. With PMI coverage, the Lender realizes an additional $40,000 for the risk in underwriting this loan transaction.

Because PMI payments are not tax-deductible, the Borrower should keep track of the PMI fees especially if the Borrower is systematically making an extra mortgage payment to Lender with instructions to have the additional payment applied to the loan principal. Once the equivalent of 20% equity (cash; not appreciated value) is paid into the property, the Borrower, in some cases, can ask the Lender to remove the PMI policy which may reduce the monthly mortgage payment.

Presently, Lenders have loan programs which allow the Borrower to pay less than the standard 20% down payment and remove the Borrower's obligation for PMI; such as 80/20 loan packages. Check with your Lender for the most current loan programs available to you.