Typically when purchasing a home, you provide 20% of the home value as down payment in the form of cash and obtain a loan for the remaining  80% of the home value. Putting  20% down means your mortgage lender considers you less of a risk, because if you default on your mortgage and they foreclose on the home, they can usually sell it quickly for at least the 80% value that they contributed.

If you are unable to provide 20% of the home value in cash, lenders usually require you to buy private mortgage insurance (PMI). You may also need PMI if you are refinancing your home and have less than 20% equity. PMI protects the mortgage lender from you defaulting on your mortgage payments.

PMI does not provide you, the borrower, any protection. You are required to hold the PMI policy until you have 20% equity in the home. Once the balance of your loan drops to 78% the purchase value, the lender is required to cancel the policy.

You can pay for PMI in a few ways: it can be added to your monthly mortgage payment; it can be paid in one upfront premium at closing; or some combination of the two. PMI fees vary, but are typically around 1% of the original loan amount each year.

Imagine you are borrowing $180,000 and only putting down $20,000 instead of the normal $40,000 down payment. While 1% may not seem like much, PMI is $1,800 additional dollars each year on top of the repayment of principal and interest.

In this example, monthly premiums will cost an additional $150 on top of your mortgage payment of $808, bringing the monthly total to $958. It will take 66 months, or just under 5 and half years, to reach 80% equity in the home when you can cancel your PMI policy. Over these 66 months you will spend an extra $9,750 on monthly PMI premiums.

The additional interest you will pay to borrow the extra half of the down payment will be $12,331. This means, it will cost a total of $42,081 in interest, PMI, and repayment of principal just to borrow the additional $20,000 of down payment.

It’s easy to focus  on the amount of the monthly payment when you consider  what loan you can afford. It is important to understand each piece of that monthly payment so that you have a clear idea of exactly where your money is going and why.

PMI will cost you thousands of extra dollars, which you may not realize you are spending if you are only focusing on the monthly amount you are paying each month. PMI  should be avoided if possible, but it may seem like your only option if you don’t have enough cash available for a down payment.

Fortunately, this is not the case. While the most common option is to save for a down payment before purchasing a home, there are other alternative ways to fund a down payment, including borrowing the funds in other ways or using a pledged asset account or buying a smaller house now for which you can put 20% down and “trading up” later after your investments and equity grow.

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