Definition
The abbreviation PMI stands for Private Mortgage Insurance, which is an insurance policy issued to protect lenders from default on a loan. PMI is normally required by lenders when the loan to value is greater than 80%, meaning the equity in the home is less than 20%.
Calculation
Loan to Value (LTV) (%) = (Remaining Principal of Mortgage / Purchase Price of Home) x 100
Explanation
Private mortgage insurance will pay off the remaining principal of a loan if the borrower goes into default. This mechanism provides protection to lenders. In doing so, it also allows homebuyers to purchase a home with a small upfront payment. Over time, the mortgage's principal will decrease, and the equity in the home should increase. Eventually, PMI will no longer be required by the lender.
Since PMI is collected as part of the monthly mortgage payment, some borrowers may be paying for insurance that is no longer needed. Lenders have an application process that can remove the requirement for PMI; however, a professional appraisal may be required to authenticate the value of the home.
Private mortgage insurance is a tax deductible expense.
Example
Lindsey wants to buy a house for $400,000, but only has $60,000 for a down payment on the home. In this example, the loan-to-value would be:
= (($400,000 - $60,000) / $400,000) x 100
= ($340,000 / $400,000) x 100, or 85%
Since the LTV is greater than 80%, the lender will likely require Lindsey to pay PMI. This insurance payment is collected by the mortgage company on a monthly basis, along with monies for an escrow account.
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