Private Mortgage Insurance (PMI) is a type of policy a lender can take out if a loan applicant is unable to make a down payment of 20 percent of the home's purchase price. While the lender is the holder of the policy, the homeowner is the one who pays for it. PMI has become increasingly necessary as real estate prices continue their upward trend, so it helps to understand how PMI works to protect you, the lender, and other home buyers.

The Theory

When a buyer is unable to put down 20 percent of the home costs, they have very little equity in the home. Should they be unable to afford their mortgage, the lender would be responsible for the sale of the property. PMI is there recoup closing costs, real estate agent fees, and taxes, as well as cover any depreciation or repairs on the property.

PMI keeps interest rates lower because the insurance company is taking on the risk, and not the rest of the market. It also provides a strong incentive for homeowners not to foreclose on their home. PMI can usually be canceled as soon as a homeowner reaches 20 percent equity in their home. It's also tax deductible for families who make less than $109,000 a year (adjusted gross income.)

The Costs

Most homeowners in the United States pay between .5 – 1 percent of the purchase price of the home per year. The cost is highly dependent on the actual percentage of the down payment. So a 5 percent down payment is going to be far higher than if putting down a 15 percent down payment. If you're planning to take out PMI, the advice is always going to be to put as much toward mortgage payments as possible.

As soon as a homeowner reaches 20 percent equity, they can cancel PMI forever. Most homeowners bundle the costs of PMI into their monthly mortgage payment, but they do have the option to pay for it all upfront.

The Warnings

There are a few warnings about PMI, depending on the buyer's circumstances. For example, it's not always recommended to pay for PMI in one lump sum. If a homeowner has to move for some reason before reaching 20 percent equity, they may lose any unused PMI.

The exact costs of PMI a homeowner pays is dependent on the lender they choose, so buyers are highly encouraged to do their research before choosing one. Legacy Ridge homeowners should also research the cancellation process. Some insurance companies make the process so lengthy and complicated that it takes months to finally close the policy.

The Options

There are lenders that don't require PMI in the case of a less than 20 percent down payment. Instead, they'll bump up the interest rates on the loan instead of charging for PMI. It's possible that this option will be less expensive than PMI in the long-run, but definitely not a guarantee. Talking to an experienced real estate agent plus a tax specialist is normally the best way to determine which option is the best financial decision. Other lenders may require PMI for a set amount of time, rather than as a condition of equity.

With fewer and fewer buyers able to put 20 percent down on their home, lenders turn to PMI to protect themselves from potential mortgage default. Buyers will need to explore a variety of lenders to choose one with PMI requirements that fit their timeline and budget.