Private Mortgage Insurance, also known as PMI, was developed to safeguard banks and other mortgage lenders against a possible default by the home buyer. Home buyers are almost always required to pay for PMI insurance if their downpayment on a home is less than 20% of the home's value. Should an individual decide to stop making the house payments, for whatever reason, the lending bank will repossess the house. The insurance company that underwrote the PMI policy will typically pay off the bank whatever the difference proves to be between a 20% downpayment and the amount that was literally paid in the down payment. So if an individual put down five percent on the house and then defaulted, the insurance company would reimburse the lending institution the remaining fifteen percent of the purchase price that the person did not pay the bank.

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It is true that the lending bank is receiving protection against default that the home buyer is having to actually pay for with private mortgage insurance. So what does the home buyer gain out of this arrangement? The home buyer receives the ability to purchase a house with a smaller amount than a twenty percent down payment. In the past, banks would never make a loan to an individual or couple that would not put down the significant and expensive down payment. They felt that it was simply too much risk. Thanks to the invention of PMI, banks are willing to make loans to individuals who pay only five percent down. This has made it far simpler for the prospective home purchaser to actually buy his or her home.

It is important to note that private mortgage insurance is almost always paid along with the person's monthly mortgage payment. The mortgage company will add the PMI premium to your monthly mortgage bill, and will take care of setting up PMI with an insurance company.

PMI amounts are calculated according to a somewhat complicated formula. The actual dollar amount varies per the amount of the down payment being protected. Typical monthly PMI rates can be ascertained by dividing the total mortgage amount by a figure determined by the actual amount of down payment. For example:

If downpayment is 5%, then divide the total mortgage amount by 1,500

If downpayment is 10%, then divide the total mortgage amount by 2,300

If downpayment is 15%, then divide the total mortgage amount by 3,700

The resulting number from dividing the mortgage amount by the amounts listed above yields the monthly dollar payment of PMI. For any reader who prefers the fully technical explanation, have a look at the formula from which the above numbers are derived:

Loan Amount * (Interest Rate + 0.021) * Loan Percentage (i.e., 0.95, 0.90, or 0.80) ^ 13 * 2.

As a concrete, real world example, assume that a home buyer purchases a $100,000 valued house and then puts a down payment of 5% down. The down payment is then $5,000, while the mortgage amount is $95,000. Simply divide the $95,000 mortgage amount by 1,500 to get the actual monthly PMI expense, which in this case is $63 per month. If the home buyer purchased a $250,000 priced house and then made a 10% down payment, then the down payment amount would be $25,000, and the mortgage would total $225,000. $225,000 divided by 2,300, as per the table above, gives a monthly PMI payment of $98 a month. Remember that this can vary depending on the insurance company, but this formula is a good general guideline.

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PMI payments can be canceled once the home equity reaches twenty percent. This is because that is all the banks was being protected against, the first twenty percent of the home price. Policies will automatically cancel once the home equity grows to 22%. A home owner can be proactive and cancel his or her PMI insurance coverage once the 20% equity amount is achieved.

When the property market values are appreciating, individuals may be able to get out of their PMI insurance policies quicker than by slowing paying down the loan amount. Going back to the first example above, if a person put down $5,000 on his $100,000 priced house, and then the home value roared up to $119,000 in only a few years as a result of a booming property market, then the person will be able to get out of PMI early. The person benefits from not only the $5,000 which they put into the house, but also the $19,000 in value which it has increased. So $24,000 equity exists. This translates to a greater equity position than 20% of the original price of the house, which was $20,000. So long as an appraisal demonstrates to the home lender that the equity is real, then the PMI will be allowed to be canceled by the lender.