Like many terms in the real estate industry, it can be hard to really get a handle on what a term like “PMI” means, but we’re breaking down the facts behind PMI once and for all. Read on to see what it actually means, how it works, and why it may have gotten a bad rap.

So, what exactly is PMI?

“PMI” stands for Private Mortgage Insurance.

These days, it’s common for lenders to require it in order to be approved for a mortgage if you plan on putting less than 20% down on the home.

Since buyers who make lower down payments have less automatic equity in the home, they’re considered a bigger risk. Therefore, banks require these buyers to take out a mortgage insurance policy for their protection. These policies shield the bank against loss in the event that the buyer stops making mortgage payments. And, if the buyer defaults on the loan, they have the ability to recoup their investment through the policy.

It’s important to note, however, that this policy will not protect you, as the buyer, if you decide to stop making mortgage payments.

If that happens, your credit score will suffer and you could end up losing your home to foreclosure.

How does PMI work?

How your PMI functions will depend largely on the loan program you choose, so you’ll want to ask your lender to go over the specifics with you in depth. That said, there are a few factors that impact every policy.

They are:

Rate

Again, the rate you pay will depend largely on the loan program that you choose. FHA loans are standardized while conventional ones are more variable. With a conventional loan, your rate is determined by the lender, based on your credit score and loan-to-value ratio, or how large of a down payment you’ve made. Typically, the higher both those things are, the lower your rate will be.

As a general rule, PMI tends to run anywhere from $30-$70 dollars per month for each $100,000 that was borrowed. If, for example, you purchased a $300,000 home, you could generally expect to pay between $90-$210 per month towards your policy.

Payment

Payment methods also vary by policy. However, there are a couple of common options. All FHA loans, as a rule, are paid in the same manner. They come with an initial upfront payment towards your premium and then a recurring annual payment each year that you hold the loan.

Conventional loans, on the other hand, work on a case-by-case basis. In some instances, your PMI is tacked on to your monthly mortgage payment, along with your mortgage interest and other fees. Like these fees, this portion of the payment does not go towards paying down your principal or building equity.

In other cases, you may have the option to make lump-sum payments or to finance your entire premium through a smaller loan.

Length of policy

This is another instance where FHA and conventional loans differ. Since FHA loans are government-backed, they require that you pay PMI for the entire length of the loan. Conventional loans, on the other hand, typically will allow you to drop your PMI once you build up more equity in the home. Usually, once you’ve paid off over 20% of the loan. However, you’ll want to check with your lender to verify the details of your specific policy.

How to avoid paying PMI

If you’re against paying PMI, you do have some options to avoid having to take out a policy.

These are the most common ones:

Conventional loans

Typically, if you can qualify for a conventional loan and make a down payment of 20% or more, you won’t be required to take out a policy.

VA loans

Thanks to the GI bill, the PMI requirement is waived for qualified veterans. You also have the ability to finance up to 100% of the home’s value.

Physician loans

Many physician loans also forgo this requirement

Portfolio/non-conforming loans

Since portfolio and non-conforming loans each have their own unique set of terms, you may be able to find some options without a PMI requirement.

Piggybacking

“Piggybacking” refers to the practice of taking out an additional, smaller loan to cover your entire PMI premium upfront. However, keep in mind, that with this tactic, you’ll have an additional monthly payment to contend with, one that may come with the higher interest rates that are common among smaller loans.

Though having to pay PMI is not the most fun thing in the world, it’s not always the root of all evil either. It’s crucial to talk your lender about the loan as a whole before choosing the best option for you.

Often, the PMI requirement gives banks enough security to allow them to offer you better interest rates than they would if it wasn’t there, meaning you may actually end up paying less in fees over the life of your loan, all things considered. Be sure to do your research before agreeing to any specific loan terms.

 

This article originally appeared on OpenListings.