Why 20% (and not 30% or 40%)?
The bigger the protective cushion, the better for the lender. But keeping the down payment requirement too high deters homebuyers even more (because they need more of their own money to buy the home).
20% is believed to be an optimal point where lenders are protected in a large majority of scenarios (because a 20% drop in home value and the borrower defaulting at the same time is a low likelihood scenario). At the same time, 20% is reasonable enough for a fairly large number of buyers to buy those homes.
Let’s get back to the importance of PMI and how it helps?
Lenders require 20% down payment, as we now understand. But what if a borrower has less money to buy the home?
Lenders don’t want to risk making a loan with a protective cushion smaller than 20%. They want to help homebuyers, but the more important goal for them is to protect their own capital.
In such a case, for conventional loans (i.e. non-FHA and non-VA loans – More on that later), there are private insurance companies who are willing to take that risk on behalf of the lender in exchange for a monthly premium.
Say, for example, the borrower has only 10% available for down payment. In such a case, the lender will ask the borrower to buy insurance to protect the lender in case of a foreclosure and the property selling for less than the loan amount.
If you are required to buy PMI, the mortgage payment will not only include Principal and interest, it will include an additional payment, the “monthly PMI premium”.
Advantages of disadvantages of PMI
There is one big advantage and one big disadvantage of PMI.
The advantage – It lets homebuyers buy a home without having to wait till they have the full 20% down payment.
The disadvantage – The obvious disadvantage is the higher monthly cost for the borrower.
In other words, people who pay for PMI are those who think that the advantage (of owning a home sooner) outweighs the disadvantage (of paying extra every month).