PMI stands for Private Mortgage Insurance. If you pay less than 20% down on your home purchase or obtain a loan greater than 80% of your home's value, you will most likely have to pay PMI. Many people are still paying it on loans obtained many years ago. The definition of equity in a home is simple. It is the home's market value minus the mortgage balance. It is thus easy to calculate, if you know these two figures.

Having PMI in place reduces a lender's cash risk in a mortgage default scenario. That's why they require it. They are risk averse.

Assuming a decent credit rating and a small down payment, most any potential home buyer can secure a loan for a house. This is so because these transactions are secured by a very valuable asset: the home itself. If a borrower defaults on a loan, the risk for the lender is theoretically only the difference between the value of the home and the amount outstanding on the loan, less the amount it costs them to foreclose, maintain, pay taxes and resell the property. There is also an implicit opportunity cost if the asset is illiquid for any length of time. That is to say, if they have money tied up in a foreclosed house they can't sell, then they can't use that same money to back further loans that would make money for them.

For this reason, lenders are historically wary of lending more than a certain percentage of a home's value. Traditionally, in the U.S., this has been 80 percent. The cushion this loan ratio provides the lender helps ensure that the losses from loan defaults are kept to a reasonable, or at least an acceptable, level. In market downturns, however, properties become more difficult to sell in a timely manner and may require price discounts to sell.

In modern times, it has become increasingly more common to see home buyers using down payments of 10%, 5% or even 0 percent. Most FHA loans today require a 3.5% down payment. Most VA loans have a 0% down payment. Naturally, loaning this much presents the lenders with a lot more risk than if the buyer put down the traditional 20% (or more). To offset this risk, these transactions typically require Private Mortgage Insurance or PMI. This supplemental policy protects the lender in case a borrower defaults on the loan, and helps in those situations where the value of the house falls lower than the loan balance.

For many years, in a robust economy where home values were stable to rising, PMI was a large money-maker for both the insurers and the mortgage lenders (who get a commission). Foreclosres were fairly uncommon. However, this type of insurance can be most onerous to the insurer in a down market, when foreclosures rise. They have to pay off banks right and left and may actually become insolvent.

The amount of the insurance premium varies but can range, for example, from $60-$80 per month for a $200,000 house. Since it is a very important part of the loan process, the premium payment is commonly rolled into the mortgage payment to prevent the borrower from overlooking it. Given the size of the overall house payment, this additional fee is often semi-hidden to the borrower and sometimes forgotten about.

Homeowners continue to pay the PMI for years and in the meanwhile the mortgage balance decreases as it is paid down. In the same time frame, there is the chance that the home value may rise (though this hoped for value gain is dependent on market forces), a factor which I will address further down the line.

At a certain point, a point where the lender should feel safe, the borrower may can get this insurance premium removed. Thus, it is prudent for the borrower to carefully consider the threshold point where the loan balance has dropped to the "standard" 80 percent threshold. Since this reduction occurs mathematically as a result of amortization over time (assuming no re-financing), at some point the mortgage balance will quite methodically reach the 80/20 point. Then, the home owner can apply to remove the mortgage insurance that has been in place. Each mortgage company has an in-house process that must be followed, however.

Interestingly, the owner can actually accelerate this process in several ways. One way is to double-up on house payments whenever one can manage it financially. This extra payment activity increases the rate of amortization, reducing the principal balance faster.  This is generally considered prudent. Another way is to upgrade the home's value with remodeling, renovation, augmentation and new site improvements.  However, this must be done without altering the mortgage or the lender's risk. Another way is to apply a lump sum cash reduction that lowers the principal balance substantially. This may occur when the borrower has an unexpected financial windfall or decides to utilize savings in this manner.

Until recently lenders were under no obligation to tell home owners when they had reached a point where the PMI could be dropped. That all changed in 1999, when the Homeowners Protection Act took effect. In most cases, this law now obligates lenders to terminate the PMI when the principal balance of the loan reaches 78 percent of the original loan amount. Savvy homeowners can get off the hook a little earlier. The law stipulates that, upon request of the home owner, the PMI must be dropped when the principal amount reaches only 80 percent!

It is important to note that this law only applies to home loans (whether first time or refinances) that closed after July, 1999. Also certain other conditions must be met, such as being current on the loan payments. Buyers that purchased before July 1999 can also have their PMI removed, but they must initiate the process; and, the lender in these cases is under no obligation to do so. Ethical mortgage companies are often consumer oriented and offer notification but not all. Plus, without an appraisal, the lender doesn't really know the actual point the threshold is reached. They rely on the original appraisal, which may be out of date, and the mortgage balance according to amortization as determined mathematically. The only accurate figure they have access to is the amortization figure, assuming it has been calculated correctly.

This means they can easily miss the true point attainment of the threshold literally by many months and even years.

And, there is another passive but key way that home owners equity can attain the "magical" 80/20 percent ratio. Those areas of the United States where there have been significant gains in the value of real estate can have properties that more quickly reach the threshold.  In fact, prior to the recession, certain areas saw rapid appreciation levels on an annualized basis that increased the market value of thousands of U.S. homes. It is thus not uncommon, in stable or rising markets, for people to find that the value of their property has risen to the threshold fairly quickly -- the point where the amount of principal they owe on their loan is at, or less than, 80 percent of the home's current value. Again, for older cases, the lenders are under no legal obligation to remove the PMI. In most cases, however, as long as the home owner has been prompt on their loan payments and doesn't represent an exceptional risk, ethical lenders may agree to remove the extra fees. This has changed somewhat since the advent of the recession, and more lenders are carefully considering the risks related to falling market values in homes and higher foreclosure rates.

The hardest thing for most home owners to know is: just when does their home equity rise to, or above, this magical 20 percent point? Well, you have to know the market value of the property. A certified real estate appraiser can certainly help and an appraisal will likely be required by the lender as part of their process. It is an appraiser's job to know the market dynamics and values of homes in their market area. They know when property values have risen or declined. Many appraisers offer specific services to help customers find the value of their homes and remove PMI payments. Faced with this data, the mortgage company may be convinced to eliminate the PMI insurance premium.

It is interesting to note, that the savings achieved from successfully dropping the PMI premium can pay for the appraisal fairly quickly, often in a matter of months. After that time, the home owner can enjoy the savings from that point on.

What is, for example, an $80 per month savings worth for say 20 years (240 months) worth? The nominal cash figure is $19,200, over time. The present value of this is considerably less, but more often than not still worthwhile to pursue. Has your reached the 80/20 threshold? First get a printout from your mortgage company of your amortization schedule and your current mortgage balance. Bear in mind it will change as payments are made. Estimate how much your home is worth, in your own mind. If possible get a Realtor to help in making this determination. Even without the benefit of an appraisal's precision, it may be apparent that you are nearing or have reached the threshold.

For more information on PMI and the Homeowners Protection Act, try one of these links:

Cancellation of Private Mortgage Insurance: Federal Law May Save You Hundreds of Dollars Each Year