PMI stands for private mortgage insurance. It’s an insurance policy your mortgage lender will take out to cover a portion of the amount you borrow in case you ever default on your loan.
This means if you stop paying what you owe on your mortgage and the lender forecloses on your property and suffers a loss, the insurance company will pay out a claim to the lender.
Even though PMI protects the lender, you are the one who must pay the premiums. That’s why it’s a good idea to avoid PMI when buying a home. It’s an extra cost, and it’s not something that’s necessary to have on your mortgage.
So how do you avoid it? By taking one of these actions:
Put Down 20%
The most straightforward way to avoid PMI when buying a home is to put down 20% upfront when you get your mortgage. When you put down 20% of a home’s purchase price in cash and finance the other 80% of the homes's value with a mortgage (aka "80% loan-to-value ratio"), your loan presents less risk to the lender.
The more equity you have in a home purchase, the less risky the loan is for a lender. The risk for a lender is that you may default on your loan and the lender must foreclose on you and take the home back for sale. The lender will then sell the home and recoup from the sale proceeds the money they lent on it in the first place. If the lender is forced to foreclose and sell the home in a down market, there’s a possibility that they may not get all their money back. Considering that selling a home costs between 6-9% of the sales price in commissions and other expenses, just a small drop in home prices can put the lender in danger of a loss on the loan amount.
When you put a full 20% down on a home, this initial equity creates a safety buffer for the lender to get their money back in the case of default. The lender doesn’t need insurance against the loss because of this buffer.
But a 20% down payment helps you in other ways, too. It may help you secure a better interest rate because you look like a less-risky borrower versus someone who puts down a smaller amount of cash. It means your monthly mortgage payments will be smaller since you borrowed less. And in some real estate markets where there is significant competition for listed properties, a 20% down offer will appear stronger than an offer with a smaller down payment, and the listing agent may be more likely to consider stronger offers.
Get a Different Type of Mortgage
Of course, coming up with 20% of a home’s purchase price in cash is no small feat. Sometimes it is really hard. For example, if you want to buy a home that costs $400,000, a 20% down payment means saving up $80,000.
You could plan to buy a home later to give yourself enough time to save up the money you need. But life doesn’t always work out that way. Sometimes buying sooner rather than later is the preferred way to go, for a variety of reasons.
Or you could consider lowering your budget and looking at lower-priced homes on the market. Buying a cheaper home means you don’t have to save up as much to reach that 20% mark.
However, that doesn’t always work, either. If you’re in a seller’s market, a highly desirable and competitive area, or simply in a city where real estate prices are higher than average, you might have a difficult time finding a home you like, in a location you like, and home prices could rise in the meantime.
One alternative is to use a different kind of loan called a “piggyback” or “80/10/10” loan, which is basically a second loan in addition to your primary mortgage. You need to save 10% in cash for a down payment, and the lender will originate a second loan for an additional 10%.
This type of loan allows you to finance a home and get a mortgage for 80% of the purchase price, without PMI.
However, that second loan is still a loan — meaning it’s more debt. It also comes with its own interest rate, which is usually higher than on the primary mortgage. And it usually needs to be paid back in 15 years, rather than 30 years. In other words, this is not necessarily more affordable than simply putting 10% down on a home and accepting PMI. And this type of financing is not always available.
Pay a Higher Interest Rate Instead of PMI
If you want to stick with the traditional mortgage and still avoid PMI, there is one other option. You could ask for lender-paid mortgage insurance. That means your lender would pay the mortgage insurance.
However, there is a catch. Your loan will carry a higher interest rate to cover what would have been an additional insurance premium for the coverage. The interest could be up to 0.5% higher. With a higher interest rate, you will pay a lot more in interest over time. Essentially, the lender is passing through the cost of PMI to you.
For that reason, this strategy doesn’t work for all borrowers. Increasing your mortgage interest rate by even half a point can cost you tens of thousands of dollars over the lifetime of a 30-year loan. And this rate hike lasts as long as your loan does, whereas PMI can typically be removed once you build at least 20% equity in your home.
Use a Home Co-Investment
The efforts you take to avoid PMI when buying a home can end up costing more than the insurance premiums themselves. You need to be careful when accepting higher interest rates or taking out multiple loans to buy your home.
There is another alternative – using a home co-investment from a company like Unison. The way this works is Unison will add money to your down payment. That means if you can save 10% of a home’s purchase price in cash, Unison can contribute another 10% — giving you a total down payment of 20%.
That way, you can avoid PMI when buying a home.
The money provided by Unison isn’t a loan and there are no monthly payments or interest charges. Rather, the company invests alongside you in your home. When you eventually sell the home, up to 30 years later, Unison receives a portion of the appreciation or depreciation in the home’s price.
This is a great way to get the funds for a 20% down payment and avoid PMI when buying a home. And that’s without taking on more debt, paying a higher interest rate, or taking on multiple loans to purchase your home.