If you put less than 20% down, it increases risk in the eyes of mortgage lenders. They usually then require you to do certain things to offset that risk. If you get a conventional loan — which most people do — lenders manage the risk of that smaller down payment with private mortgage insurance, or PMI.

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PMI 101: The cost of putting less than 20% down

First-time homebuyers are often under the impression that they need to put 20% down in order to buy a house. Actually, though, the vast majority of buyers put well below that amount down. The National Association of REALTORS® reports that last year, all homebuyers made a median down payment of 18%. First-time buyers put a median of just 9% down. 

And you can go even lower than that. Usually, lenders will go for as little as 3% down. The trick, though, is that they see a smaller down payment as a bigger risk. And they charge the borrower for that in the form of private mortgage insurance, or PMI. 

How much PMI costs

PMI adds to your monthly mortgage payment, potentially by a three-figure amount. 

Fannie Mae, a government-sponsored enterprise (GSE) also known as the Federal National Mortgage Association, reports that PMI averages range from 0.58% to 1.86% of the loan amount annually. 

Splitting the difference, let’s use a rate of 1.22%. If you get a $350,000 mortgage, you’ll be on the hook for $4,270 in PMI premiums each year. That means PMI would add more than $355 to your monthly payment. 

To understand why lenders add such an expensive insurance product to your loan, it helps to dig into something called your loan-to-value (LTV) ratio. 

The link between loan size, your home value, and risk

Insurance is designed to defend against risk. When you’re thinking about buying a house, you’ve probably thought about protecting your investment with homeowners insurance, for example. This way, if a fire breaks out or a vandal tags your fence, you have some financial assistance to help you out. 

You’re not alone in this. Mortgage lenders think about risk mitigation all the time. It’s why they charge a higher interest rate to borrowers who look less likely to repay their loan (e.g., those with a lower credit score). 

In short, lenders want to make more money off riskier borrowers to offset their exposure. That’s where PMI comes in.  

LTV ≤ 81% = PMI

One of the ways lenders evaluate risk is by looking at a specific mortgage’s loan-to-value ratio. You calculate the LTV ratio by dividing the loan amount by the value of the house. If you get a $350,000 mortgage on a house valued at $400,000, for example, the LTV ratio is 87.5%. 

Lenders like a lower LTV ratio. This way, if you stop repaying your mortgage, they’re more likely to be able to sell your house for enough to cover your loan balance. 

This is doubly true if you get a conventional mortgage. That’s any home loan that isn’t backed by part of the federal government like the Department of Veterans Affairs (VA) or the Federal Housing Administration (FHA). Without the protection that comes with insurance from a federal agency, lenders take steps to protect themselves.

As a result, if you borrow a mortgage with an LTV of 80 or above, you’ll almost certainly have to pay for PMI. 

The good news: PMI isn’t permanent 

PMI can add a hefty chunk to your mortgage. But you’re not stuck with it forever. Thanks to the Homeowners Protection Act of 1998, also called the PMI Cancellation Act, you can get rid of private mortgage insurance once your LTV reaches a certain threshold. 

A couple of benchmarks apply here. First, you can request PMI removal as soon as you get to an LTV ratio of 80%. This makes sense since you’ll have reached the LTV ratio that you would have started with had you put 20% down.

At the 80% marker, you can reach out to your lender and request the cancellation of PMI. If you’re not feeling like undertaking the effort, though, you can also wait it out. Per the Homeowners Protection Act, your lender’s legally required to cancel PMI once you hit an LTV ratio of 78% of your home’s original value (how much it was worth when you bought it). 

If, for whatever reason, you haven’t hit that threshold by the time you’re halfway through your loan term, your lender also has to automatically terminate PMI. So if you reach year 15 of your 30-year mortgage, your PMI should fall off. 

More good news: you might be able to get rid of PMI faster than expected. Because home values have been on the rise, some homeowners saw rapid appreciation. This meant hitting the 80% LTV benchmark  — and consequently having the ability to request PMI cancellation — relatively quickly. Not all lenders offer this kind of value-based PMI cancellation, but it’s well worth asking. 

Evaluating your loan options — and if PMI is worth it

The thought of adding a hundred bucks or more to your monthly payment probably isn’t a welcome one. But paying PMI can be well worth it if you’re in a good place to buy right now. Because a lot of lenders accept a down payment as low as 3%, you might be able to get into a house — and start building equity — sooner. 

There’s another thing you should know, though. Making a smaller down payment usually means being charged a higher interest rate. Still, if homeownership is a priority, buying now might make sense. 

Playing with some different loan scenarios can help you determine if PMI and a higher interest rate are worth it to you. With our rate tables, you can adjust the down payment amount to see what it changes for you. Start comparing rates to get a better feel for your options today.