A row of homes in a suburban neighborhood
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When you’re looking to buy a home, a 20 percent down payment is recommended. While it’s not wrong to have a smaller down payment — you’ll still be able to buy a home — it does have some setbacks. Like the need for private mortgage insurance, or PMI.

What is private mortgage insurance?

If you’re buying a home, lenders require private mortgage insurance as part of a conventional loan to protect them in case you end up in foreclosure. PMI is also required if you refinance your mortgage with less than 20 percent equity.

PMI is a layer of protection for lenders, but an added expense for borrowers. Conventional loans are the most popular type of mortgages, but they’re also the one that isn’t insured by the government.

FHA — or Federal Housing Administration — loans and Veterans Affairs (VA) loans are backed by the government. If you default on your loan, FHA and VA loans protect you. For conventional loans, private mortgage insurance acts a protector — but for lenders, not for borrowers. If you default on your loan, PMI makes sure lenders get their money.

The good news is that having PMI can help you qualify for a mortgage if you otherwise couldn’t — especially if you don’t have a 20 percent down payment. But not everyone can get a conventional loan; many require good credit scores to get approved.

How mortgage insurance is calculated
Based on purchase of a $200,000 house with a 10 percent down payment, borrowing $180,000. Buyer has a 770 credit score.

*Rate varies according to size of down payment, credit score and insurer.

Insurance rate 0.3% per year*
Loan amount $180,000
Annual premium $540
Monthly premium: $45

Source: Bankrate.com, Radian mortgage insurance calculator

Most PMI policies require the borrower to pay monthly. Borrowers also have the option of paying for mortgage insurance with a large upfront payment.

Can you get out of private mortgage insurance?

While PMI is required for some loan agreements, it’s not for all. Here are a few ways to avoid private mortgage insurance.

  1. Put 20 percent down. The higher the down payment, the better. At least a 20 percent down payment is ideal if you have a conventional loan.
  2. Get an FHA loan. The minimum down payment for an FHA loan is 3.5 percent. This is a good option if you have less-than-stellar credit, but the closing process could take a little longer with this option.
  3. Cancel it. If you couldn’t get out of private mortgage insurance when you bought your home, keep track of your payments. Once the loan balance reaches 80 percent of the home’s original value, you can ask the lender to drop the mortgage insurance premiums.

How can you pay for private mortgage insurance?

PMI fees vary from around 0.3 percent to about 1.5 percent of the original loan amount per year. This depends on the size of the down payment and the borrower’s credit score. Mortgage insurance paid in 2017 is tax-deductible, but it’s unclear whether Congress will renew the deduction for 2018, as the Trump administration is overhauling the tax code.

There are a few different ways to pay for PMI, including:

  1. Monthly. Most PMI policies require you to make monthly payments. This is an additional charge added onto your monthly mortgage bill.
  2. One large payment. Sometimes, lenders require PMI to be paid in full at the time of closing. You can see if yours does in your loan estimate.
  3. Both. Sort of like a down payment, you might be able to pay some of your PMI upfront and the rest in your monthly mortgage payment.

Loan-to-value ratio

The loan-to-value ratio, or LTV, describes mortgage debt as a percentage of how much the home is worth. It is a financial term used by lenders.

Formula: Mortgage amount owed / Appraised value

Example: Alex owes $60,000 on the mortgage. The house is worth $100,000.

$60,000 mortgage balance / $100,000 = 0.6. This means that Alex’s loan-to-value ratio is 60 percent.

How do you know if you should get PMI?

Getting private mortgage insurance is typical for conventional loans, but you might not need to get it. Make sure you’re considering all your options before agreeing to get PMI. Some factors include:

  1. Shopping around. If you settle for the first lender you get approved from, you might end up paying more in interest and insurance. Don’t agree on a mortgage without going over many different options first.
  2. Bump up your down payment. Remember that 20 percent eliminates PMI. If you can spend a little extra time saving for a higher down payment, you’ll be able to lower your monthly payments in the long run.
  3. Review other types of loans. While conventional loans are the most popular, they aren’t the only kind. Look at FHA, VA, and other types of home loans to make sure you’re getting the right one for your situation.

Private mortgage insurance can add to your monthly expenses. When you’re buying a home, check to see if PMI is worth it for you.