Probably few subjects in real estate raise more questions or generate more confusion than the matter of private mortgage insurance, or PMI.

PMI is important because nobody -- including you, me, and virtually every lender who finances homes -- wants to make high-risk loans. To avoid excess risk, lenders are willing to finance homes with 20 percent down. Why? Because if a buyer defaults and a home must be sold at foreclosure it's still likely that the lender's money will be completely recovered if the buyer paid 20 percent up-front.

But not everyone has 20 percent to put down. If lenders had an iron-clad rule that only purchasers with 20-percent down could buy, we would be a nation of renters and both real estate demand and home values would be greatly reduced.

The solution is to allow buyers to purchase with less down, and one way to do that is to make a trade: less cash up front in exchange for a guarantee to lenders from a strong third party.

This is the concept behind VA and FHA financing where borrowers can purchase with little or nothing down: If there's a default the government will compensate the lender for much or all of the loss.

But while the VA mortgage program is excellent, not everyone has the service experience necessary to participate. And while the FHA program has historically helped many entry-level buyers, in recent years the program has been beset by high insurance costs, excessive appraisal requirements, and loan size limitations.

So what's a would-be borrower to do?

One choice is to save for a 20 percent down payment. Saving such a large chunk of money can take years, meanwhile if home prices rise so will the number of dollars required to put down 20 percent. (Of course, home prices can also fall, a matter which should comfort no one.)

An alternative works like this: buy now, buy with what you have, and use PMI instead of a hefty down payment.

PMI is a common borrower choice, according to Jeff Lubar, director of communications for the Mortgage Insurance Companies of America (MICA). In 1998, says Lubar, nearly 1.5 million borrowers used PMI, approximately 1.1 million financed with FHA loans, and 385,000 bought through the VA program.

There are various PMI plans and they typically work like this:

• The more you put down, the less coverage you need. In other words, more insurance is required with 5 percent down, less insurance with 15 percent up-front.

• Adjustable-rate mortgages, ARMs, are perceived as more risky than fixed-rate loans, thus PMI costs are somewhat higher.

• The borrower pays for PMI coverage, but if the loan is defaulted, the lender is the policy beneficiary.

• It is possible for a lender to conditionally approve a loan, and also for a PMI company to decline coverage.

There are costs for PMI coverage (hey, it's insurance), typically monthly premiums based on the amount of outstanding debt. For cost details and payment options, speak with brokers and lenders.

So far we've seen that with 20 percent down you don't need PMI. But what happens if you buy will little down and the value of your property increases so that you now have 20 percent equity? Should not PMI coverage end?

Assuming full and timely payments, the logical and obvious answer is yes.

Which brings us to the HomeOwners Protection Act of 1998 (HPA), legislation that covers mortgages originated after July 29, 1999 for the purchase, initial construction, or refinancing of a borrower's one-family principal residence. It provides that if the borrower has a good payment history, then once the original debt has been reduced to 78 percent of the original purchase price must be canceled.

The rules also allow borrowers to request PMI cancellation after they have reduced their loans 20 percent. However, in addition the guidelines also permit lenders to retain PMI coverage for 15 years in the case of so-called "high risk" loans.

The HPA requires lenders to notify borrowers about their cancellation rights. In addition, the MICA site has cancellation information online.

If you look at the HPA standards you can see that they exclude mortgages made before July 29, 1999 -- tens of millions of loans. The standards also do not apply to FHA loans, mortgages which require insurance payments throughout the entire loan term -- a policy that may explain why FHA has a cumulative surplus of $16 billion.

The new rules relate the cancellation of PMI to a reduction of the original loan amount -- not the difference between the current loan balance and the property's present value. This means if you borrow $100,000 at 8 percent interest over 30 years, you'll pay $733.76 a month for principal and interest. The loan balance will not dip below $78,000 until 14 years and six months later. By then, most likely, you will have sold or refinanced the home.

Is there any reason lenders cannot adopt standards which are more liberal and reasonable than the federal guidelines? No. And the good news is that many loans allow for early PMI cancellation.

As examples, Fannie Mae and Freddie Mac buy loans from local lenders. Their rules establish standard practices for lenders nationwide, and when it comes to canceling PMI both have adopted guidelines which are well within the realm of reason.

Fannie Mae and Freddie Mac say this: If you have a loan they own, if you have a good payment history, if the loan-to-value ratio of your home is not greater than 80 percent, and if you ask, then there is a good case to cancel PMI coverage.

Let's look at these standards individually.

• Both Fannie Mae and Freddie Mac consider how much you owe versus the property's value, not just a reduction in the loan balance. This means you may have owned a home for five years, paid down relatively little on the mortgage (because home loans are interest-heavy up front), but seen home values rise. Between your original down payment, amortization, and rising property values you now have 20 percent equity. With good credit you may well be able to cancel PMI.

• How do Fannie Mae and Freddie Mac know what your home is worth? They don't. This means you must be able to show that your home has a given value. The way this is done is by having an appraiser approved by your lender value the property.

• What's an "acceptable payment record?" Freddie Mac says borrowers must have no late payments for the past two years. What's a "late payment?" A payment at least 30 days overdue. For Fannie Mae, good credit means no payments 30 days late for at least one year and no payments 60 days late for two years.

• Implicit in these rules is a period for loans to "season." This means if your home suddenly shoots up in value three days after you move in, you should still expect to continue PMI payments. Under Fannie Mae's rules, for instance, a loan must season five years if a cancellation is sought with 20 percent equity, but only two years for 25 percent equity.

• The cancellation request rules for both Fannie Mae and Freddie Mac apply to loans made before July 29, 1999. This means there are cancellation opportunities for millions of homeowners.

• If you have an older loan (one made before July 29, 1999), do not request cancellation, and your loan balance has been reduced to 78 percent of its original value then PMI coverage will likely end early next year. By January 2, 2001, older loans with sufficient mortgage reductions should see PMI premiums canceled automatically if such loans are owned by Fannie Mae or Freddie Mac.

• The PMI cancellation standards do not apply to FHA financing because federal rules require insurance payments for the entire loan term in most cases.

• To get PMI canceled early, you must take the initiative and contact the lender who collects your payments. Ask who owns your loan. If not Fannie Mae or Freddie Mac, check the policies of the loan holder. Many are also updating PMI cancellation standards.

The effect of the Fannie Mae and Freddie Mac rules is this: Whether your equity comes from a down payment when you first buy or from equity accumulated over a period of years shouldn't matter -- 20 percent is still 20 percent, and if you have 20 percent equity and good credit you shouldn't have to pay PMI fees.

Published: December 27, 2000

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Peter G. Miller, also known as OurBroker®, is the author of six real estate books -- including The Common-Sense Mortgage -- and is the original creator and host of America Online's Real Estate Center. Peter's weekly columns appear in more than 100 newspapers nationwide, he is also published in a variety of other media outlets and he is a frequent speaker at national events and conventions. Peter welcomes your questions, comments, and news releases via e-mail at .