Millions of homes have been financed with private mortgage insurance (PMI), a type of third-party guarantee that allows buyers to purchase homes with substantially less than 20 percent down. But while buyers are happy to have PMI when they purchase, they also want to end such costs as quickly as possible.

Until recently canceling PMI has been complex if not impossible. Lender policies varied, several states had cancellation requirements but most did not, and there were no federal regulations regarding the issue. When presented with a cancellation request, a lender could just say "no" and in most cases there was little, if anything, that could be done.

However, under the Homeowners Protection Act of 1998 (HPA) federal cancellation requirements have now been established. In essence, the federal rules address the worst cases of PMI abuse, those situations where a loan has been paid down significantly and yet the lender refuses to allow consumers to cancel PMI policies.

Under the new rules, when your loan balance drops 20 percent below the original purchase price you can request PMI cancellation. When your loan balance is 22 percent below the original purchase price, then PMI is canceled automatically. The rules only apply to loans made on or after July 29, 1999.

The HPA rules do not apply to millions of older loans, FHA financing and VA loans. In the case of VA financing this is not an issue because VA loans only have a one-time, up-front fee. With FHA however, the situation is different. Under new regulations, for FHA loans made after January 1, 2001, the monthly Mortgage Insurance Premium (MIP) can end once the loan balance is reduced to 78 percent of the original amount.

Federal rules being federal rules, there are exceptions. For instance, lenders can keep PMI in place for half the loan term -- 15 years for a 30-year mortgage -- when dealing with a "high risk" mortgage. Since the rules do not define the term "high risk" there is no way to tell how it might be applied.

Even under the new regulations, it can take years to cancel MI. For instance, in the case of a property bought for $105,000 and financed with a $100,000 loan at 7 percent interest over 30 years, it will take 11 years and 10 months before the loan balance reaches 78 percent of the original amount -- assuming no prepayments. Press here to try the loan cancellation calculator provided by the Mortgage Insurance Companies of America (MICA), the industry trade group.

The catch, of course, is that most loans are not outstanding 11 or 12 years.

The 2000 Profile of Home Buyers and Sellers published by the National Association of Realtors says that "repeat homebuyers in 1999 had been in their previous homes for a median of seven years -- an increase of one year from 1989. A quarter of repeat homebuyers had owned their previous homes for three years or less. A third of repeat buyers had been in their previous homes for at least 10 years."

But even if people stay in their homes, there's a strong likelihood that their original loan has long-since been refinanced. Dave Warner with the Mortgage Bankers Association says "the life of a typical mortgage is about 7 years."

What's missing here is any credit for appreciation. The PMI cancellation formula relates to the original purchase price but provides no benefit for rising home values.

Should appreciation be considered when evaluating whether or not to end PMI? Of course. Lenders surely look at appreciation when refinancing a property, and appreciation is important when it's time to sell.

Go back to the home purchased for $105,000 and financed with a $100,000 mortgage. Imagine that the market value increased 3 percent annually and the loan balance was reduced through regular monthly payments.

As the chart shows, if we look at the loan-to-value relationship instead of the loan-to-original price, owners can achieve 20 percent equity in far less than 11 years and 10 months given reasonable price appreciation. And once owners have 20 percent equity, then just like buyers with 20 percent down PMI should be canceled.

Lenders, for their part, need protection in this process. The property is their security in case the owner defaults on the loan and it's entirely reasonable for lenders to require proof that the home actually has 20 percent equity. This can be easily done with an appraiser named by the lender and paid by the owner.

Also, there should be "seasoning," a period of time after a loan is originated so that lenders can see a clear pattern of full and timely mortgage payments. Two years seems fair and reasonable.

The issue here is not the legitimacy of PMI -- it's a perfectly-valid financial product. Without PMI large numbers of buyers, especially first-timers, would be excluded from the marketplace and that would have the effect of reducing both consumer demand and home prices.

But the fact that PMI has value should not be seen as a license to continue PMI payments long after they are necessary to protect lenders. The good news is that those who buy loans are increasingly willing to end PMI coverage when borrowers can demonstrate both solid equity and a good payment history.

For instance, Fannie Mae, holder of perhaps one loan in four nationally, now has an automatic PMI termination provision that applies to "all mortgages closed before 07/29/99, as well as to any mortgages closed on or after 07/29/99 that are not covered by the Act's termination and cancellation provisions." Fannie also says it offers "borrower-initiated cancellation based on the current value of the property, a cancellation option that is not required by the Act."

Freddie Mac says it will "allow borrowers to cancel MI when their mortgage reaches 80 percent of the property's value, provided that certain conditions are met. These conditions include a record of timely payments as well as verification of the property's value."

Freddie Mac, which may hold one loan in six nationwide, says lenders can "determine property values through broker price opinions, a method that is more streamlined and less expensive than a traditional appraisal." The company points out that it will only accept appraisals or BPOs when "ordered by the lender for the purpose of determining whether mortgage insurance can be canceled."

For details regarding PMI cancellation, speak with your lender and also check out the cancellation information found at PrivateMI.com.

For more articles by Peter G. Miller, please press here.