There's a reason it's not always so easy to get a mortgage. Because lenders take on a certain amount of risk every time they give out a mortgage, they need to employ different measures to protect themselves. One such tactic is charging private mortgage insurance. Private mortgage insurance, or PMI, is a way of allowing mortgage lenders to minimize their risk. Lenders typically impose PMI on borrowers who fail to make a 20% down payment when applying for a mortgage. If your home loan has a loan-to-value percentage that's higher than 80% (which means you put down less than 20% of your home's value), you should expect to pay PMI.
Protection against default
Lenders give out mortgages for the purpose of making money -- specifically, by collecting interest. When you go to pay your mortgage, you'll notice that a large portion of your monthly payment is applied to interest on your loan, as opposed to its principal. This especially holds true during the early years of your loan. Those interest payments are what keep lenders in business, and so their greatest fear is that you, as a borrower, will stop making payments on your loan, thereby eliminating their income stream. The reason lenders require PMI is to protect themselves in case a borrower defaults on a home loan.
The cost of PMI
The problem with PMI, at least from the borrower's perspective, is that it can be expensive. PMI is typically equal to 0.5% to 1% of the value of your home loan. So if you take out a $300,000 mortgage and are required to pay PMI at 1%, you'll add $3,000 a year, or $250 a month, to the cost of your mortgage.
PMI is typically paid as a monthly premium that gets added to your regular mortgage payment. This extra premium, however, can make it more difficult to keep up with your homeownership costs. For this reason, it's often best to hold off on buying a home until you're able to come up with a 20% down payment.
That said, PMI can help you qualify for a mortgage you may not otherwise be approved for. Despite the fact that PMI makes homeownership more expensive, it can also be a reasonable solution for someone who earns a good living and can handle the costs of owning a home but hasn't had a chance to save up a lot of money.
Furthermore, just because you start out with PMI doesn't mean you'll always be required to pay it. You can typically request that PMI be canceled when the loan-to-value ratio on your mortgage falls to 80%. Furthermore, lenders are actually required to cancel PMI when your loan-to-value ratio drops to 78%.
The upside of PMI
While most borrowers would rather avoid PMI, if you do need to pay it, there's some good news. Just as you can deduct mortgage interest on your taxes, so too can you deduct your PMI premiums -- that is, as long as you don't earn too much money. As of 2016, the PMI deduction starts to phase out for single tax filers earning $50,000 a year and joint filers earning $100,000 a year. Furthermore, single filers earning more than $54,500 a year and joint filers earning more than $109,000 aren't eligible for the deduction at all.
If you're looking to buy a home, considering waiting until you've saved up that 20% down payment before applying for a mortgage. Though PMI can open to the door to homeownership, it can also be a costly way to finance property. And the more you spend on housing, the less wiggle room you'll have in your budget to cover your remaining expenses.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.