Private Mortgage Insurance, or PMI, is insurance required by most lenders which is purchased by the borrower to protect the lender in case the borrower defaults on the loan.

If you make a down payment of 20% of the cost of your home, the lender has good reason to trust that you will make your mortgage payments faithfully to protect your large investment. Besides, the lending institution will probably come out ahead if forced to foreclose on your house. This is because the lender loans you 80% of the cost of the house but will recover close to 100% of the cost of the house. But, if you make a smaller down payment, such as 5% or 10%, and borrow the rest, and you default on your loan, the lender risks losing money. So, lenders require you to purchase mortgage insurance, which will guarantee them payment on the balance of loans not covered by the sale of foreclosed properties.

Mortgage insurance dramatically increases your buying power by allowing you to put less money down on a house. So you can buy a home sooner because you don't have to wait until you can pay 20% up front. Or you can purchase a larger or more desirable home that you could not otherwise afford. Repeat buyers can use a lower down payment to claim more tax-deductible interest while they invest the cash from the sale of their old house or use it to pay other debts or expenses. Of course, a lower down payment does mean that you will pay more in interest in the long run, but mortgage insurance does increase your options.

An initial premium will be included in your closing costs and a monthly amount in your house payment. The good faith estimate of closing costs, which you will receive after you complete your loan application, includes an estimate of the premium and monthly cost of PMI coverage. The HUD 1 Disclosure Form, which you sign at closing, will give requirements for cancellation. Not all investors allow cancellation, but some will permit the borrower to cancel their mortgage insurance after a year or two of timely mortgage payments which have decreased the risk to the lender.

If you think you might consider cancelling your mortgage insurance after a few years, you should find out whether your insurer allows cancellation, what the conditions are, and how much it could save you before closing on your mortgage.